Prof Dholakia: the policy rebel within the MPC

Prof Dholakia: the policy rebel within the MPC

V Kumaraswamy

The term of the first Monetary Policy Committee (MPC) has ended with the government nominees retiring at the end of their non-renewable and non-shrinkable 4 year term coming to end in September 2020. The Government has nominated Dr Shashanka Bhide, Dr Ashima Goyal and Prof Jayanth Varma as replacements for Dr Ravindra Dholakia, Dr Pami Dua and Dr Chetan Ghate.

Given its current orientation – banking on the lending side at least is largely industry and service focused – it would have been desirable to have an industrial economist or more appropriately an industrialist on the panel. If customer centricity is the prevailing buzzword, it would have been most welcome to have someone who could share with the committee the situation and consequences of policy actions.

Hopefully, Dr Bhide with his unique smell of the soil will bring in the necessary native knowledge to the proceedings. May be there is a case for broad basing the skills without increasing the number.

While the functioning may have been cohesive, whether the content and policy prescriptions were appropriate and optimal has been in doubt. How much the monetary policy framework is a contributor to the current run of economic sluggishness is yet not widely understood but that the date of birth of both coincide should give rise to doubts to the discerning. For on many occasions it seemed largely prescriptive in nature based on some borrowed ideals.

Prof Dholakia mostly appeared like the rebel within. And truth be told his dissensions captured the ground realities better than the official statements often.

Probably he was never comfortable with the concept of monolithic or prescriptive nature of the Dr Urjit Patel Committee’s (UPC) recommendations that has guided our monetary policy making since early 2014. As early as in 2014 he had countered the rationale articulated by the then Governor for setting up UPC. In an article published in Economic and Political Weekly in July 2014 he had concluded as follows:

 “It is clear from the discussion that the RBI Governor’s assertion of there being not serious trade off between inflation and growth in the country does not get any support from recent empirical evidence. On the contrary, deliberate disinflation would impose a sizeable immediate cost of loss of output on the system. His second assertion on the direction of causality also does not have any clear supporting evidence…” (Page 168, EPW July 12, 2014. But given the time for publication this must have been written much before the committee finalised its report).

That he found a place in the MPC speaks of the Governor’s and the Government’s encouragement of dissensions for enriching the debate.  

For him it is not the ideal but the optimal – one which weighs the costs and benefits of policy actions that counted. As briefly mentioned in 2014, he went to calculate the sacrifices made for every 1% variation from the optimal or natural rate of inflation and the prescriptions of Monetary policy. In an article published (with Mr Kadiyala Sri Vrinchi) by the reputed Journal of Quantitative Economics (April 2016), he proceeded to calculate the sacrifice ratio (the % of output sacrificed in order to obtain one percentage reduction in the inflation rate) based on a fairly long period of 18 years of Indian data. The sacrifice ratio is summarised in the table below:

 Estimates of Sacrifice Ratio (SR)
Inflation measureShort run SRLong Run SR
GDP deflator3.62022.2396
CPI3.29671.7329
WPI2.98242.2404

The numbers are not insignificant for an economy stuck with low employment growth and more onerous task of pulling people out of poverty. Especially for anyone aware of the deficiencies involved in calculating any statistics in India, the validity, narrow base, considerable lag and poor quality to enforce an ideal rate of inflation against an actual sacrifice of the above magnitude must seem wasteful.  His dissensions should be seen in this light and not intent of adding more heat than light to the debate.

He proceeded to arrive at the optimal rate of inflation for India as 5.4 to 6% while presenting his annual Presidential address to The Indian Econometric Society in January 2020. (it was later published in JQE in September 2020).

Based on the regressions on data between 1996 to 2018/19 he observed, “current targets are fixed for combined (states and centre) fiscal deficit at 6%, for CAD at 2%, and inflation at 4%, for a growth at 8%. These are not internally consistent targets, because with the given targets of FD, CAD and inflation rate, consistent estimate for the long run growth as seen (in the table) is only 5.6%—a shortfall of whopping 2.4% points!!”

His equations conclude that to reach 8% growth India would need 2.5% CAD, and fiscal deficit target of 6.5-7% and inflation of 5.4% to 6%.

Probably it explains his preference often for accommodative stance. One only hopes there is a serious review of the inflation targeting levels as well as the approach in the near future. While the targets appear too low, the approach cannot be divorced from our state and stage of growth, degree of integration, and monetary policy reach.

The current state of sluggishness cannot be validly analysed without removing the huge impact that the specific levels of inflation targets as well as the fiscal glide path given by the FRBM review committee whose recommendations again have been prescribed without calculating the optimal or sustainable levels with the result both have started operating as constraints on our growth.

A faster one time debt restructuring

A faster one time resolution plan

This appeared in Businessline today. https://www.thehindubusinessline.com/opinion/a-quicker-way-to-do-one-time-loan-resolution/article32489800.ece

RBI has been both sensitive and fast in dealing with Covid crisis. It has constituted a committee of eminent persons under KV Kamath with a tight and functional deadline. Laudable as it is, one requires a non-discriminatory and non-discretionary yet speedy mechanism at this time to tackle the crisis.

The committee will no doubt come up with a valid and justifiable set of criteria for onetime restructuring. This may have some industry wise criteria, some client-health specific criteria, some bank-client history specific criteria.  Whatever be the recommendations of the committee, its guidelines would involve application thereof which would call for discretion by bank officials at different levels including at Board level in major cases.  

This process involves time – to get revised projections from clients and justify such restructuring – to write up the proposal and present before the sanctioning committees at whatever levels, documenting such approvals, new amendment agreements, etc. involving great lot of efforts and lead times.

There is a great deal of inertia induced by the recent spate of financial frauds discovered and the way it has been dealt with in full public view.  The trouble with such ‘exemplary’ punishments is it affects the psyche of the honest (who make the near total majority) much more than the people who game the system. The net effect is a definite slowdown in systems and risk aversion.

Our public sector systems depend too heavily on the top for decision making. Most such functionaries are closer to retirement and prone to risk aversion, except where possibly the decision making is collective like at Board or committee level. Between protecting his borrower and their own pensions, they can’t be faulted for preferring their self-interest.

A faster approach may have been as follows:

  1. All principal re-payments due on loans could have been slid down by a year and all dates (beyond Mar 2020) in all existing agreements (as of March 2020) could have been deemed to read as one more year than mentioned in the repayment schedule. For example if the repayment was to be in 2020,2021, 2022, they should be mandated to read as 2021, 2022 and 2023 respectively.
  2. All interest payments due during the year, if the clients are not able to service could be accumulated and converted into a loan for 3 years with a small increment of 1% over the present documented rate, which clients may choose not to avail.

These could be legislated so amendments to individual loan documents made unnecessary. That will leave no discretion and hence neither bribe seeking/offering would be possible nor would risk aversion be necessary. This would be the fastest to implement. Such a systemic boldness has been demonstrated by Brazil thrice during the last century but in a different matter when they cancelled the last 3 digits in all their outstanding currencies overnight (like all 10,000 Reals were to be read as 10 Reals from next day morning). 

Banks would be rid of NPA and provisioning worries. Their cash flow for relending may be diminished but they are stuck anyway for both lack of inflow and not many credit worthy clients to lend.

It would still leave foreign loans. But the foreign banks are quick on such decisions and generally lot less cowed down by personal fear psychosis.

Firms which have been profitable even after Covid impact may not have to suffer any credit downgrades if the Credit Rating agencies sensibly factor in the match the obligations with the scenario after Covid subsides. Such firms may face the dilemma whether to seek re-scheduling or not for fear of stigma by rating agencies and lending banks in future. It would save them such blushes.

Those who have declared losses in the last 4 months would gain by interest moratorium and may have to deal with residual concerns.

If the Government could also sanction changes in Accounting Standards to capitalize all interest, forex losses and may be even Covid losses (even if not funded by banks), it would help in preventing many firms from breaching ratio covenants in most cases. Ratio covenants play a heavy role these days in decisions to lend, rating, and determination of rates.     

a Mix of Inflation and devaluation could tame Covid financial losses.

Overcoming Covid created financial crisis with a mix of devaluation and Inflation

V Kumaraswamy

The financial jolt from Covid virus should surely count as 3-sigma event or perhaps even 6-sigma. The global meltdown 2008, East Asian Crisis and Dotcom bubble seem to stand nowhere near this. They didn’t chock the physical economy as much as Covid. While the final loss count would depend on how long Covid continues, assuming it continues till end of September at the very minimum it is likely to shave off our GDP by 10-12% compared to previous year, leave alone the lost growth. That’s is a whopping Rs 20-25 lac Crores. RBI’s recently announced onetime restructuring addresses the liquidity issue but laves open the solvency issue completely open.  

Who should bear the Loss?

There is a huge systemic economic loss during Covid19 and we have to devise the least harmful way to share it between government, business, banks and people.

The Government bearing the losses will amount to about 3-4 years’ fiscal deficit in one go – simply too disastrous to the fiscal health. Government should focus more on revival through new investments and bail out others only to the extent it helps it in its effort of revival: it should limit its support to only the vulnerable sections of people (say income-wise bottom 20%) and firms. It would do well not to aggregate all the losses of private individuals with itself by bailing them out. Where would it load such losses? It ultimately has to load it back on the citizens through GST or Income taxes. The Government should therefore focus on the poor mainly by way of food security and medicare.

Businesses – both big and small – have accumulated a more than fair share of the losses and it will soon transmit to banking system thru credit downgrades. Many of them will become economically viable once the economy gets going, but have to service the additional losses accumulated during Covid period with their existing assets. When this inevitably transmits to the lenders, many a bank will suffer and the financial system might be too debilitated to support the revival investments required.      

We need to find novel ways of spreading the losses over a fairly long time. Examined below is one such measure of using a mix of devaluation and inflation by using forex reserves which is built for extreme contingencies but remains side-lined due to oppressive orthodoxy and perhaps lack of boldness.   

Suggested way by using Forex Reserves

India should de-value its currency by 12-15%. There will be a huge valuation gains on Forex reserves to RBI – may be $ 50-60 Billion in INR equivalent (say 3.5 to 4 lac crores). As law stands today, this unrealised valuation gain cannot be distributed as dividends to Central Government. But if we can be bold like US Fed Chairman and Treasury Secretary during 2008 crisis, and say what is not expressly prohibited is deemed permitted, the gains can facilitate RBI investing an equivalent amount as Equity in banks upto 15%. The banks can be permitted to buy back the equity so issued whenever Banks meet some designated criteria in the next 5-7 years. SEBI norms should be relaxed to facilitate this.

Alternatively, RBI can directly liquidate 10-15% of its forex $ assets and subscribe to the banks’ equity. The level of one year’s imports is too wasteful earning 1-2% returns (much below their costs) and if it is not used at this 6-sigma like crisis, what is its use!  

Use by Banks

This equity to banks can be used to write off (or provision) 10-15% of loans to all MSMEs, Mudra loans, and select other segments the criteria for which can be defined by a reputed committee following of whose directions can absolve the bank officials of any wrong doing and post retirement raids. Alternatively, the interest for one year can be written off for qualifying units – may be for all those who are paying the salaries as evidenced by withdrawals or interest for 12 months from date of restart, thus incentivising restart. The amount so written off can be recovered by hiking interest rates by about 1-2% over the next 5-7 years, enabling the banks to return the equity to RBI.  

Hopefully the Rs 3-4 lac crores write offs if properly targeted will save many bankruptcies. This in turn may save banks thus avoiding chain defaults and degrades both at corporate and bank levels leading perhaps to India country downgrade.

The central government’s efforts for avoiding downgrade by keeping a tight fist on stimulus spends as is seen now, can come to naught if many businesses go belly up leading to bank downgrades. So better to save the situation even if unorthodox.

Thus RBI can front end the losses through valuation gains. Banks can carry the write offs temporarily. And recover through 1-2% additional interest and ½% additional interest towards Covid interest fund. This will compensate the banks for their one time write off and the banks can pay back RBI with the money so recovered, thus completing the cycle over 6-7 years.    

Moment of reckoning for free trade theorists

I have always had my quarrels with Free trade. It was much like solving a simultaneous equation taking into account only one of the equations and ignoring the other. Good to see some noted votaries start deserting it. My article in Businessworld. would most welcome critical comments.
Article
Moment of reckoning for free trade theorists.

Free trade theory has always had its flaws. It is just that some diseases take a long time to manifest. Noted votaries of free trade theory are switching sides of late and sure more will follow in the days to come or lose relevance. Sure specialization has benefits but to think it is limitless in its application and would hold its ground irrespective of rigid political borders and impediments to factor mobility across political boundaries, overcome man vs machine issues exacerbated by savings glut is being naïve at best.

Unresolved half way truth
An economy is a circular prototype with producers on one side and consumers on the other, salaries wages and factor payments from one side, market prices from the other, capacity utilization on the producers’ side translating into employment on the other.

Any escape from one side in this circular system to outside entities (say of purchasing power of consumers spent on imports) has to be compensated by inflow of purchasing power, if the economy is not to shrink in size. Businesses would need to compensate this loss with exports to maintain their capacity utilization or it needs to be compensated by inward investments. Otherwise the system would shrink at a lower level of GDP than without free trade induced imports and exports.

When all economies are expanding, there may not be any nation facing absolute decline in income but no one would notice any relative decline compared to true potential without free trade. Theoretically if there are 10 nations in free trade any number from 10 to 1 can be gainers. The others may be losers in relative or even absolute basis (GDP lower than previously). So there is a possibility that all the gains from trade are garnered by a single nation at the expense of all the others.

While there is a torrent of theories on how gains from trade can be generated from cross border specialization, they left the distribution question vaguely and naively to negotiations. In that sense, it is a mathematically well-reasoned theory till the half way stage – covering the first leg but not its consequences. It was time that its shortcomings manifested themselves.

Failure to notice breakdowns
Any persistent trade deficits and current account deficit is sure a sign that trade is not beneficial and that any readjustment of skills and products to specialize in is not working. The country may be digging for copper since it is its comparative advantage by giving up digging for gold but the price of gold and copper may be such that the country becomes a net importer value wise. Unfortunately the prices copper or gold does not get decided only by costs for the theory to work perfectly.

There are twice as many losers due to trade (countries with persistent trade deficit) as gainers from trade (countries with persistent trade surpluses).

As consumers the citizens even in countries with persistent deficits will be happy with a wider of choice of goods and cheaper prices, but the same citizens have to face a slack job markets where businesses would not be able to provide them jobs to all those who seek it, unless the trade gets balanced at the country level. Little will they realize that their welfare comes at mounting debt at the country level which the future generations or they themselves have to settle in the future.
China’s productivity levels for labour, industry and services are 30%, 33% and 29% (all figures for 2015) of frontier efficiencies of advanced economies, as per IMF studies (2019). That China was clocking 10-13% growth rates for years on end despite such huge gaps in its productivity levels should have alerted the free trade evangelists like Nobel Laureate Krugman. But they failed to look behind the smokescreen how despite such low comparative productivity levels, China was competitively pricing its products right across a spectrum far wider than such low%s would suggest. China could not have done that without manipulation of currency and factor (esp labour) markets. China’s labour markets are hardly free and the share of labour in the GDP is nowhere near what would have been if labour markets were free, leave alone a fair share similar to western standards. Instead its labour was saddled with loans to upgrade their prosperity and its private debt/income is at unprecedented levels perhaps in excess of private debt levels of US before 2008.

Deceptive Protectionism – key to gaining from free trade.
The best negotiation strategy to maximize gains was very well being demonstrated by Japan in 1960s to 80s and later China even while the trade theory apologists kept believing in their half complete theories. The indoctrinated theorists watched naively as China manipulated its currencies, manipulated its own factor markets, violated IPRs, subsidized key inputs from the back end while Japan erected tight barriers to its distribution systems. Vietnam is the free trade theorists’ new poster boy; but little do they realize how with various non-tariff barriers they have zealously guarded their domestic market. ASEAN has emerged as the chief factory of non-tariff measures in the last decade (the NTBs by ASEAN outnumber India’s by 17 times as per TRAINS) and nearly half of Vietnam’s imports are subject to NTB of one form or the other.

The experience of China as indeed several others would only suggest that to win this game, one needs to know how to manipulate the rules cleverly at least as much or perhaps even more than increasing cost competitiveness. India was a naïve practitioner (perhaps free trade’s chief adherent), not clearly aware of where it’s enlightened self-interest laid and much less how to achieve it.

Flawed foundation
Even without manipulation by any of the players, the theoretical foundations underpinning free trade would suggest that there are equal chances of being a losing country as much as being a gaining country. If your country’s comparative advantage is in commodities or products with flat demand and supply curves, payoffs would be far less than resources consumed; you will most likely end up losing if the particular commodity has high point elasticity of price.

Even if the country as a whole gains, if one’s skills are in such industries as above, one is more likely to lose than gain. Unfortunately more of the poor, less skilled have their skills predominantly in such industries even in advanced countries. And the biggest threat they face is atomization of low skill jobs at rapid pace.

Even within same corporate entity production can sometimes be reallocated between various centres for reasons of efficiencies. But allocating portions of the profit of the more efficient to the one who has to accommodate is generally an impossible task. There are simply no mechanisms for doing it across countries.

Alternative
Much of the potential benefits from Free Trade can be achieved without necessarily being subject to the ill effects and distorted distribution of its gains due to machinations of rogue players. Largely similar results can be achieved by freeing domestic production and investments from controls, encouraging inward FDIs, freeing or even encouraging technology transfers and skill development i.e. promoting cost competitiveness within the economy including where necessary dismantling size related restrictions.  India can easily clock a couple of additional % of growth if only its administration and law making bureaucracy sheds its audit and suspicion mindset which erects so many detailed rules and regulations which unfortunately favours only the crooks and those confident of several sieves of the leaky judicial systems.

An evil worse than free trade
The far more dangerous offshoot can be that the anti-trade gang would equate free trade with free markets and seek to throw the baby with the bathwater. Free market within the economy negates very many troubles and lacunae of free cross border trade especially where factor mobility is not an issue or constraint. It will be easier for a plumber to move from Dibrugarh to Delhi than to Dacca which is at one third the distance. Inter trade mobility is easier within one’s own country – the plumber can more easily become an electrician within India than migrate to
Australia for a different trade even if so mandated by free trade comparative advantages.

There is a fatal risk of socialists and communists making a grand re-entry given that neither in China nor in any of the countries which have suffered due to its brand of aggressive free trade, has Labour gained – in China due to its policies of allocating much more to investments through the government and other countries due to shift in many low end industries into China which have thrown many low wage earners out of jobs resulting in heightened inequalities. If such a twist does come about, it would be an unfortunate case of replacing a minor curse with a confirmed catastrophe like socialism or communism. At least free trade works with only minimal conflict with democracy unlike socialism and communism which seek to decimate free markets.

The wake up call hasn’t come a day too soon. If the way China is seeking to use the accumulated gains of free trade for aggressive pursuit of military ambitions during Covid pandemic does not wake up the indoctrinated theorists nothing else will.

Time to move away from prescriptive macro policy making

Indian economy seems caught between tight fiscal targets prescribed under the FRBM review and a government which treats it as cast in stone despite being faced with the current crisis.

The best example of failure of the prescriptive approach is the Eurozone. The prolonged sluggishness of the Eurozone is caused mostly by the restrictive tight inflation targeting (influenced largely by Germany’s phobia for inflation given its post WWII memories), fiscal deficit targets and debt/GDP ratios which were good for a select few countries but out of context for most of the rest. Those who were already better gained in relative terms but those who were not aligned already have gone into prolonged sluggishness and some into economic coma. But on overall basis, Eurozone has not gained; it has been a massive loser – a sinkhole which the Chinese have expertly filled in to their advantage.

Prescriptive and market distorting intervention in agriculture products has been around in India for a long time along with minimum wages in labour markets. But in the recent years such an approach has been extended to other areas of macro management. Prohibitive pricing under Land Acquisition Act has virtually put it out of reach. Inflation management which was largely situational or contextual has become tightly prescriptive, where the midpoint 4% has operated more like a hard-stop cap. FRBM was loosely operated till 2016. With a rigid fiscal target and glide-path and Debt/GDP ratio, it has started impacting other macro variables like output and employment and government investments, besides putting breaks on response to a 6-sigma kind of event like Covid.

Such a prescriptive approach is born out of a lack of faith in markets’ efficiency and its self-correcting nature. Fixing targets for macro-economic variables like inflation, interest rates, fiscal deficits are as detrimental to the efficiency of free markets and its equilibrium seeking ways as fixing minimum or maximum prices in individual commodity markets or fixing quotas or tariffs, or licensing in micro markets.

A circuit breaker in stock markets at 10% and 20% might make sense, but at 3 and 4% they will affect free functioning of markets and its adjustments to new information or assimilation of the effect of other economic factors. The trouble with tight constraints is that they start affecting other factors and force them to operate at sub-optimal levels. As an example, anyone seeking air tickets or hotel rooms on internet will know that the more the conditions or filters one puts, the lesser the number of options that gets thrown up. The recent prescriptions have operated like ‘binding constraints’ in a linear programming language reducing the value of outcome than act as circuit breakers.

Free of any prescriptions major macro variables like inflation, investments, fiscal deficits, CAD, exchange rates, growth and output interact with each other influencing and being influenced by others so that the markets seek optimal or equilibrium ways. Such interplay also keeps the others in check so that they don’t escape their gravity. The experience of communist countries has proven that market based equilibrium have been far more enduring and self-sustaining with fewer glitches. Prescriptions should be like circuit breakers for extreme 3-sigma events like East Asian meltdown, Dotcom bubble and 2008 and Covid.

Are there risks in letting markets play

Will inflation, for example, run away to 20-30%. Or interest rates go sky high and snuff out all investments. Or Exchange rates break loose and settle at Rs 120/$. In an open economy where most commodities as well as finances can be imported or exported there is little risk in a general inflation shooting through the roof – import parity prices will ensure domestic prices cool down. Sudden swift exchange rate variations are to release pent up pressure. If the exchange rates fall far too steeply, higher exports and greater incentive for overseas Indians to bring back money will soon cool it down. Any spikes in interest rates will increase the investments attractiveness and bring in moneys from savings here and overseas and cool it down.

Unless the government resorts to absurd 30-70% increases in MSPs (as it did in 2008 and 2010) extreme food inflation is unlikely. With our excess stocks and production of food grains there is no need for food inflation fears; surely in contingencies we have enough forex reserves to import food and cool down prices – something markets will do anyway.

Safeguards

Safeguards if any should be limited to extreme events – specified or emerging- something that has a 1% or 2% chance. For some most essential items like food it may be necessary. But even in such areas it may be better to let the market find its level but compensate the vulnerable through cash transfers.

During the 10 years before 2013, we have had some of the best growth years when the inflation range has been 4-10% and fiscal deficits were in the range of 6.4% to 3.3% with an average of around 4.7%. Surely there was a causal connection between these various factors, when they were managed with caution than prescription. To aim 4% and 3% respectively tantamount to ignoring these causalities and give hygiene factors the status of main deity. These then operate as constraints which pull down the potential of others.

When the history of China’s stupendous rise from 1980 to 2020 is examined carefully 2 things might become clear. FED’s Volcker’s constricting inflation control during the 80s diluted US’ investment spurs and helped China to grow green shoots and the self-negating Eurozone policies of the last 2 decades helped consolidate it further. Europe, once the cauldron of new ideas in many facets of science and technology and corporate governance is regrettably having to shield itself from Chinese investment invasion now.

Before we learn about Chinese manufacturing excellence, we might learn some lessons on how they have managed their economy.

India seems fatally infatuated to Eurozone ways and replicating the resultant sluggishness.

India can sustain a fiscal deficit of 6%

A sustained and synchronised recovery path

The three important reason for the currently stagnant economy are (i) a monetary policy which is not synchronised with the fiscal (ii) disconnected with the rest of world in real terms in an increasingly open economy and (iii) mistaking risk aversion for sustainability (of government debt and deficits). Our FRBMs are forcing the government think more like an individual in retirement mode: pay off debts and resist fresh ones as if its sources of income are to dry up soon.

Considering the current strengths, the following can be the action agenda for getting out of the current rut. The aim is to have integrated fiscal and monetary policies. The sustainability of these are demonstrated later.

  1. RBI to maintain real interest rates (RIR) at +/- 0.5% of select competing countries/economies. This will preserve India as an attractive investment destination for inbound investments besides staying competitive for domestic investor. This has become disengaged of late due to nominal anchoring in an open economy, as can be seen in the chart. Since 2013, our Real Interest Rates has gone off into a different orbit.

Slide2

  1. RBI to target a GDP deflator of 6% p.a. for the medium term. This together with RIR will establish the target nominal interest rates. Within this food and essential inflation may be targeted at 3-4% to ‘protect the poor’.
  2. Government to aim at Tax GDP ratios in line with other countries (those chosen for real interest rates) – increase it by 2-3% over next 5 years.
  3. Target real growth rate and spend as if we are growing at 7%. If government continues to spend at 7% when the economy is growing at 10%, lower spends will cool down the economy and when the economy is growing at 4% act as a booster – an automatic stabiliser.
  4. Central Government to increase its debt levels to 52.5% from the present 47.8%. The overall debt limit is to be 60%, with 7.5% being kept as ‘Cushion’ to be tapped only for tackling extreme exigencies like prolonged war, events like oil shocks, extreme natural national calamities, 1997/2008 type of contagious external shocks, etc. Any deviation to be brought back to these levels within 2 years of economy retracting to the anchor assumptions of 7% real growth and GDP deflator of 6%.
  5. Government to switch over to accrual accounting from cash accounting and integrate extra budgetary resource (EBR) within the meaning of fiscal deficit. (One reason why the interest rates for the government has not fallen in line with the steep fall in fiscal and primary deficit numbers is the EBRs and Government compete in the same market for the same investors. And since there are multiple agencies placing essentially the same instrument, the pricing power of the central government gets diluted).
  6. Although Industry and agriculture are State subjects, CG will play the stabilisation and balancing role for business cycles.
  7. Subsidy list and quantum to be agreed between states and centre. Subsidies to be limited to basic necessities of food, clothing, shelter, and creating conditions for equality of economic and social opportunities including education, skills, basic healthcare and hygiene. All other subsidies to be part of state budget for which a limit as % of States GSDP to be applied. No subsidies to be mandated on non-government players.

Sustainable glide path

The above are tested below for sustainability of debt/GDP levels, primary and fiscal deficits. These are demonstrated below using standard equations laid out by IMF, Economic Survey (2016-17) and FRBM review committee report.

The government should increase its debt to 52.5% in 3 years. This would involve much higher primary deficits on which additional interest will have to be paid. The governments revenues grow at nominal rates of growth say 13% year on year. But Primary deficits which add to debt have to be serviced at 7-8% only. So one has to balance and equate the additional taxes with serving costs of PD. This is signified by the FRBM review in its report as pdt = (gt-rt)/(1+gt)*dt  (derived from the equation in page 54 of report). Table 1 captures the sustainability.

A primary deficit level of 2.3% is consistent with 52.5% debt/GDP levels and 8% GOI borrowing rate. Based on the above assumptions it is possible to sustain a fiscal deficit at 6% at the Central Government level alone. If we want to rein-in the states, we can mandate them to maintain NIL primary deficits. The sustainable fiscal deficits are given by FDs = Dt * (g/1+g), where FD is sustainable fiscal deficit and g is nominal growth rate. Table 2 lays out the sustainable debt levels across various growth rates and debt levels.

Slide3Table 3 lays down the glide path based on above recommendations. The switch over from cash to accrual accounting might gobble up 2-3 lac crores, which is accommodated by the higher PD targets in Yr1. Since there are already ‘incurred’ expenditure the inflation effect will be muted. By Yr 2, it can keep ready viable public projects. As can be seen, it is eminently feasible.

 

Government has enough firepower to spend its way out of recession

Government is needlessly self-shackled.

V Kumaraswamy

The Government looks like a batsman wanting to play only copy book orthodox shots in death overs of a T20 cricket match. The wherewithal and the government’s ability to spend are far better than when we faced sub-5% growth last. Yet the government seems morally shackled and too ideologically paralysed and unaware of its fiscal strengths.

The virtuous looking dogmas that is sustaining the present pall of gloom are (i) that the fiscal deficit targets given are inviolable and the present situation does not call for any counter cyclical action due to shortcomings in FRBM Act or the Review Committee, (ii) the Inflation Targets (4 +/- 2%) developed by the RBI are a kind of moral or constitutional obligation, (iii) better prices mean better welfare for the people and (iv) the masochist pride over currency values – an overvalued currency is a sign of strength.

The assumptions behind false prides attached of currency values and welfare effect of cheaper prices needs to be shed. But here we will see how despite the vastly superior financial fire power at its disposal, the economy is unable to take benefit of it – rather such inaction seems to be the root cause of the problem. The assumptions concerning fiscal and inflation bounds need to be revisited by more pragmatic economists.

First the monolithic way Inflation targets have been prescribed. It will be tough to find in economic history how a fledgling economy trying to graduate from lower income to low middle contained its inflation at 3-4% or those who grew at 7-8% with such low inflation consistently. Any growth will expand demand which will mostly increase the prices while interacting with an upward sloping supply curve. Even if the current excess capacities, will require better prices to restart. There are no flat supply curve commodities especially with people’s growing quality and brand consciousness. The more the demand growth fuelled by growth in economy the more the inflation is likely to be. To prescribe a 4% central rate and follow it up with hysterical reaction even when the economy gets close to it is a sure way of supressing demand. It appears that over the last 3-4 years the low target of 4% has pulled down our growth rate to 4-5%.

No doubt the poor need protection. But when the same poor is borrowing at 3.5% per month and in some daily loan cases that much for a day, to target interest rates’ closest economic cousin inflation at 4% to protect them seems absurd and ill conceived.

Second, the fiscal deficit targets. The dissent note of the former CEA points out several lacunae in the approach and final recommendations of the recent FRBM review Committee. The report is not comprehensive nor does it deal with appropriate counter measures for various contingencies. The 3% wait either ways before Government can act is far too wide and as the ex CEA points both magnifies over heating and further depresses an economy in distress.

The government has to be complemented for the way it has built the Balance Sheet strengths of the economy but the costs it is paying is too much in current terms. Chart 1 calculates the revenue receipts, expenditure and subsidies as a % to GDP for the period 2008-09 to 2018-19 and compares how these % measure up if 2008-09 is the base year.  As can be seen, revenue receipts of the central government have fallen by 5% but the expenditure has fallen by 20% and subsidies by 32%. Even if the fall in subsidies is due to plugging of leakages, it still means contraction of government expenditure going into private hands. Moral issues aside, it will still have its economic impact. The Central Government’s capital expenditure have moved but in narrow range (albeit downwards) and have not compensated for it. Government’s fiscal rectitude has of course brought down the CG’s debt as % to GDP from 56.1% to 47.8% and the fiscal deficit from a high of 6.46% to 3.34% today. It has been commendable but it has also taken its toll.

The difference between the nominal growth rate (g) and the (nominal) interest rates that the government (r) borrows is an important measure of how sustainable the deficits can be, and ‘g’ is most likely higher than ‘r’. The government’s ability to raise taxes is a function of nominal GDP but it has to pay only ‘r’ to sustain such deficits. But as Chart 2 shows despite our great fiscal restraints, this gap has been on continuous decline, reflecting an unexplained inability to use its strength to bring down yields on government securities.

One reason may be the ‘black’ fiscal deficits – amounts parked outside through extra budgetary resources or instruments issued by CG allied institutions which compete for the same kitty as CG’s debt on eligibility criteria and hence are having their impact. And if there are multiple agencies placing essentially the same instrument, the pricing power of the central government takes a beating. Even if in the short run, it may be irksome it may be more prudent to consolidate the black and white fiscal deficits and manage them as one.

Given its enormous strengths the Government should be bold enough to cast aside (at least for sometime) the needless and contextually out-of-sync inflation and fiscal targets and spend its way to revive the economy. The government can as a first measure raise upto 1-2% of GDP and firstly clear all its pending bills (to NHAI contractors, Fertiliser subsidies and capital expenditure payments for railways and defence) that every Govt does to manage fiscal numbers. Since these expenditures have already been incurred in the past most likely there won’t be inflation from these. The balance can be for newer capital expenditure or paying off state GST dues.

I hope the government overcomes academic impositions with practical actions.

frbm 1

frbm 2

The Governments Formalisation drive may be unwittingly shrinking the economy

The current government has stayed focused on both formalization of the economy and digitization. The first focusses on bringing more of the unorganized economic activity into the formal fold by means of GST, making it uneconomical for others to deal with them, ensuring registrations under various laws governing manufacturing activity and income tax laws. While informal need not necessarily mean evasion, in practice a large proportion of them were. Informal estimates which put 45-50% within formal folds are putting formal economy in the 70-75 % now within a span of 5 years.

It has sought to push digitization by linking most of its subsidies to bank accounts, opening Jan Dhan accounts, and pushing for more digitized payments across all sections.

Both have laudable objectives. They reduce incentives for evasion, provide a level playing field for tax complaint entities besides spreading the tax base so that the burden falls more equitably on all the players rather than a select few, and increase the tax-GDP ratio.

While the salutary effects are already visible, what may have missed our attention is that such formalization may have inadvertently shrunk the economy leading to poorer growth. This article examines how indirect taxes like GST may have caused this.

Effect of Taxes

Our economy was a mixture of formal and informal sector with their various levels of evasion of taxes and dodging of other laws. With the benefits of tax evasion many of the informal and unorganized units in many industries were cost-competitive and enjoyed a fair share of the markets. But with the ‘imposition’ of indirect taxes many of them have become uncompetitive (the dotted bars representing them have moved to the right and hence unable to supply the market, in the middle graph).

It is not that all informal units will fall by the wayside. Several units in Sivakasi, Vapi, Manesar-Dharuhera, Baruch-Ankleswar, Meerut-Moradabad industrial estates – all with a fair proportion of such informal units are very competitive. They have a far better mix of India’s cheap or competitive resource (Labour) and efficient capital utilization. They will survive even after paying taxes.

The net effect of this is that tax collections of the government goes up which is a transfer from the pockets of surviving informal sector units to the government. Market prices go up and volumes adjust downwards due to price increase.

Profitability of previously tax compliant units will go up due to price increase, but of those in informal sector who are still competitive will turn worse.

In the top graph 5 of the 7 units in informal sector were competitive supplying 850 units in the market of 1350 units. After formalization and recovery of taxes from all, only 3 of the previously non-tax compliant units supplying 500 stay competitive and the balance 4 with a capacity of 850 units become unviable.

The shrinking of economic activity

How much economic activity in private sector will shrink will depend on the elasticity of demand of various newly taxed industries. Where demand is inelastic (like food and essential items) people will reallocate from other expenditure lines and maintain purchase volumes in which case volumes may not shrink much. But in discretionary items like purchase of cars or houses, people may not substitute but postpone the decision or downgrade their quality. People might settle for a smaller car or move farther out of city or reduce the size of purchase. In the above case, prices have gone up from say Rs 47 to about Rs 56 and volumes have shrunk from 1350 units to about 1250 units – a fall of 8.5%. If the demand is very elastic and people didn’t want to spend more than Rs 47, volumes would have shrunk to about 900, a fall of 33%.

While nominal incomes may shrink or expand depending upon whether the price effect overwhelms volume reduction, in real terms there will be a shrinkage due both to price increase and volume reduction.

Effect on overall Economy

Taxes need not always result in economic shrinkage. In many cases it is just a transfer from one pocket to another – Government in this case. World over Governments are more compulsive spenders and it may end up boosting the economy also.

An increase in direct taxes may not have any effect on the current volumes or price – it is just a reallocation of profits between the government and the enterprise. But since such taxes will reduce post tax returns on capital employed (ROCEs) and if the Cost of Capital also don’t reduce in tendum, they will impact investment demand directly – a phenomenon being observed now. We have seen a phenomenal increase in entity registrations under income tax, while the cost of capital have been stubborn, which is most likely to have affected the investments in informal sector.

In the case of indirect taxes, it does transfer resources and if the government spends such taxes collected there should be no effect on economy. Shrinkage in one sector will be made up by expansion in areas where government spends its the taxes so collected.

But the current formalization drive is an overall effort and would have most likely shrunk most private sectors as explained above leading to shrinkage of overall private sector economy. The government is not compensating this shrinkage by spending whatever it garners from this drive. It has instead been shrinking its own level of spends (as % of revenue and GDP). Fiscal deficit which were 6.46 % in 2009 and 5.91% in 2011 have shrunk to 3.42% of GDP by 2018 indicating in a sense that a lot of collection is going into reduction from previous levels. Thus when both private sector and Government expenditure is shrinking, the overall economy is bound to shrink.

It is to be recognized that units in informal sector employ more people per output and less capital than formal or organized sector, since employees can be downsized far more easily than capital assets. This also probably explains the job losses or joblessness of our growth story, more so after the formalization drive has gathered momentum.    

 

Formalisation

Misplaced Hopes on MSP

Misplaced hopes on MSPs

V Kumaraswamy

There is some growing frustration over governments procurement of key grains under its Minimum Support Prices (MSPs) not being to lift the open market prices of those commodities and benefit the farmers. What the policy makers and economists forget is that our MSP procurement is not an end in itself but has to be studied with its end use – distribution of such procurement under our PDS programmes and how they work at cross purposes.

Effect of MSP procurement

It is generally assumed or hoped that once the MSPs are increased the open market prices would also rise in sympathy. There is insufficient realization that such procurements hardly create incremental demand. The government has limited flexibility in increasing the quantities procured under MSP which may be a surer way of enhancing prices and how increasing farm productivity from the current levels only harms the farmer interest not help them.

The effect of procurements under MSP is quite often overestimated. It is necessary to visualize the impact of procurement operations to separate reality from hope and wishes. Lets try and understand the impact through graphical exhibits. Picture 1 orders the demand from the buyers at various prices in decreasing order of prices. The thick ridge line at the top forms the demand curve as is depicted on the left side. Any procurement by government agencies at any price leads to a kink (drawing on right side) in the normal demand curve as is shown on the right picture. It shifts the demand curve horizontally in proportion to the quantity bought (dd’ in Picture 1) at the price point equal to the MSP for the crop.

 

demand supplyIn Picture 1 due to the governments initial extra demand the total demand increases but as we will see later once the government supplies the same though PDS, the effect is neutralized.

mspdsinterplay

Picture 2 studies the combined effect of demand and supply of the same commodity as in Picture 1. The normal (without intervention) demand curve DD’ is represented by the solid blue line which shifts to Ddd’d” (partially dotted line) after procurement.

The supply curve is shown as SS’ (in solid Red line). The market price without any government intervention settles at P(free).  When the Government intervenes and procures dd’ from the market at the MSP price indicated it will move the market price of independent sellers or buyers which will not be

equal to the MSP: it will settle at lower levels. Where it will settle depends upon the elasticity of the supply curve; the flatter it is, the lesser will be the price increase. In agricultural markets there are many tiny suppliers whose cost structure hardly differs from one to another since many inputs come heavily subsidized or free to most players. Hence supply curve is often flat and highly elastic. The market price will settle at P(MSP) which is way lower than MSP but higher than the free market price of P(free).

It is a fallacy to think that hiking MSPs from the current levels will result in higher open market prices. Unless the quantities procured are increased from year on year (which will keep pushing the dotted d’d” segment further and further to the right), mere yearly MSP increases will have nil or negligible impact on open market prices.  Where P(MSP) settles will depend more on the width of dd’ than where it is above the P(free) levels. (MSPs below the free market prices are useless anyway). That’s the reason why formulas like 50% over all-in cost of farmers will prove innocuous, except benefitting those fortunate to sell their crops at MSPs directly by the Government.

Given the current levels of buffer stock in FCI go-downs, any significant increase in procurement quantities will be a hazardous exercise.

Effect of PDS distribution on prices

The crops procured under MSP are used in supplying them at cheaper (than free market prices) cost through the public distribution system to end consumers. This has the effect of changing the supply curve from SS’ (without PDS operations) to Sss’s” (partially in red dotted line in Picture 2 right side). This will lower the open market price which may even settle at levels lower than the initial free market price, as is the case in Picture 2. Will the total quantities bought and sold expand as a result of these operations? It will since production will increase due to price support and so will consumption since people more people at lower levels could afford to buy more due to lower PDS prices.  The difference between procurement and PDS supplies will be accretion/depletion to buffer stocks.

Way Out

The production of agri commodities has been surplus to requirements for several years running. The buffer stocks with FCI is far more than norms and the credit to FCI from banking system at uncomfortable levels. One way would be to export the surpluses and not supply the same back in home markets through PDS. Or sell it to private sector for food processing. Alternatively, it can allow food processors and exporters to procure crops at MSPs and reimburse the difference between market price and MSPs to them. At least the handling/storage loss can be reduced. Simultaneously, the govt should reduce the size of PDS physical distribution and reimburse the consumers through Direct Benefit Transfers even if the consumers buy their requirement in open market.

A method to tweak the supply curve by partial rationalization of subsidies on inputs to increase the market prices and thus benefit the farmers was also explored in this paper (How the Agrarian Crisis can Be Eased, June 24, 2019).

It is time we realized the areas where MSPs and PDS can be effective and where they can’t be and not be fooled by misplaced faith and theories.

Why India’s GDP numbers may be right; but so are its doubters.

Why Arvind Subramaniam is right; but Government is not wrong.

Link to the article in Businessline: https://www.thehindubusinessline.com/opinion/gdp-both-subramanian-govt-may-be-right/article28657586.ece

The ex-CEA has argued that the figures of GDP growth are exaggerated. He may be right but equally right may be the government. The tension will ease if one recognizes that it is possible to grow for some period of time without the total amount of goods and services consumed by community not increasing at all. The reverse is also equally feasible. This can happen with increase and decrease in % terms in the domestic content in value addition, or better productivity (or fall) of natural resources, etc. The crucial bridge between the two sides may be the efficiency gains and shifts in the structure of economy in the last few years.

Let’s examine the impact from efficiency gains. Business line published a few weeks ago (GST on the Highway dtd June 4, 2019) the story of a reporter’s journey with a truck driver from Chennai to Bhiwadi. He reported reaching the destination in 42.35 hrs instead of the 4 days it used to take not so long ago. The driver saved 2 days for his owner and as a bonus pocketed the petrol he managed to save from the 400 litres allowance he was allowed for the trip.

This was confirmed to the writer by an official of a leading transport company who claimed it takes 44 hours to reach Madurai from Dharuhera (Haryana) these days instead of the 4 days previously carrying cars. Only 15% of potential savings have come from GST so far; balance has come from better roads and better driver crews who operate as a team. Let’s construct (with some lenience in calculations) the effect of such savings on GDP in different scenarios.

 

Impact on GDP from Logistics savings (of the reported case)
 

 

 

Scenario —>

Before After
1 2 3 4
Customers final bill remains same; Transport company’s profits go up. Customer takes the savings (other than Drivers bonus) Customer takes away all the savings
Petrol (assumed for illustration) Ltr 400 300 300 300
Lorry Hire (day) Days 4 2 2 2
Driver gets paid for (Days) Days 4 2 2 2
Drivers Bonus NIL Petrol savings of 100 litres (assumed) NIL
Petrol price Rs/Ltr 70 70 70 70
Driver’s wage rate Rs/day 1200 1200 1200 1200
Lorry Hire rate Rs/Day 5000 5000 5000 5000
Composition of GDP
Petrol Rs 28000 21000 21000 21000
Wages to Drivers Rs 4800 2400 2400 2400
Bonus to driver from Savings Rs 7000 7000
Lorry Hire Rs 20000 10000 10000 10000
Profits to Transport Company (say) Rs 20000 32400 20000 20000
GDP (Price Paid by Customer) Rs 72800 72800 60400 53400
Fall in GDP 0 (12400) (19400)
Fall in GDP in % 0% -17% -27%

 

The volume of final services (real GDP) has not gone down but the nominal GDP has fallen sharply. If the final price remains due to market demand and supply, both real and nominal GDP will remain same. If the consumer pays less, GDP will fall due to the efficiency gains, unless there is 50% increase in other economic activities to absorb the truck and driver’s time (unlikely) or we start measuring value of driver’s leisure as equivalent to value of wages.  Here the quantum of services enjoyed has not gone down and so the real GDP should not go down. But the real GDP this is usually measured by using deflators, even real GDP will show a decline.

Paradoxical but that’s the exact reason (but contrarian effect) why big earthquakes and natural disasters are big boosters for GDP growth.

How Arvind Subramaniam and Government may both be right

India’s new normal growth looks 7%. But there have been drop in the exports in the last 5 years of some commodities like rice, raw cotton, meat and oil cakes;  construction activities have been hit, GST and demonetization have hit some cash dependent or tax evading activities, China dumping has clipped the growth in steel and tyre industry. But these may have been made good by growth in insurance services in rural areas, banking services through Jan Dhan, massive spread of LED bulbs, construction of toilets on a massive scale, etc. These may well have compensated for the decline in other areas and the Government’s stance of 7% growth may well be true.

Revisions in the GDP calculation approach takes years and they lag changes in the structure of the economy by a considerable time. Hence it is quite likely that many new sources of growth are not captured properly. Without these services in the estimate samples, the ex-CEA’s estimates may well be true.

But the real joker in the pack may be the efficiency gains in the economy. The last few years have seen significant gains in several areas. LED bulbs have grown rapidly saving huge amounts of electricity. Industries have also invested significantly in energy and utility savings. Banking has gone largely digital  cutting down long queues and wasted time; so are airline and railway tickets. Solar energy has replaced capex with opex and led to vastly reduced levels of consumption of fossil fuel. Digital books vastly reduce the consumption of paper; Netflix reduces trips to the theatre.

As illustrated in the table, such efficiency gains have a dampening effect on the GDP. The greater the gains accrue to the final consumer lower will be the GDP and growth.

And the impact from reduction in corruption. DBT reach the beneficiaries without leakage alright. But they have also taken away the jobs of several intermediaries and fixers. This has contributed to loss of several layers of jobs, even as it resulted in convenience, reduced costs, and saved loads of time for beneficiaries.

With the impact from the above factors, the GDP may have fallen as contended by of ex-CEA.

But GDP calculation is not a perfect maths.  The entire GDP calculation of Zambia is done by a single individual. A minister in Robert Mugabe’s cabinet likened measuring GDP to “trying to use a tape measure to figure out how much Coke is in this glass.” GDP is not measured by double entry book keeping; it is based on sampling with all the deficiencies that come with it. The Ex CEA’s approach is even more remote. The rapid changes that have been observed in the last few years especially since 2008, the urbanization and formalization since GST cannot be captured or compared with static sampling approach, size or methodology.

One wishes that the ex-CEA had not adopted an alarmist approach and present India’s GDP as some kind of methodological fudge. Without an examination of reasons, chains of causation, Working Paper no 354 looks more like the statistical appendix in the Economic Survey. If he had examined the reason behind fall in electricity consumption ratio (for example) from pre 2011 period, he could perhaps have come up with appropriate suggestions for perfecting the system.

Nevertheless, assuming his figures are correct, if the 4.5% has come about due to efficiency gains, better ICORs, reduced project implementation times, cost savings, and lesser inconvenience to consumers why should we be ashamed of it. These would only improve the competitiveness of Indian industry and services.