Macro Imbalance and the need for a new framework agreement

My article in Businessline today.

The chorus for reduction of Real interest rates as the panacea for the current economic stall is getting louder. From commentators to administrators to economists that seems the only item in the menu these days.

Interest rates (nominal and real), Inflation, Forex rates and Reserves, Investments, Capital Account convertibility and Foreign Investment Flows (all from the input or causative side) and Growth, Output and Employment on the resultant side are all intricately interconnected. There seems a need to look at things comprehensively and evolve a framework agreement between RBI and the Government reflecting this reality.

Illustration of Inter connectedness and imbalance

People buy things in advance if either it is likely to be costlier in the future when they need it or for de-risking (like Gold and Real estate). But what if the realized prices later consistently prove to be less? Would people still buy upfront or would it indicate some discrepancy? Lets see it in the context of forex rates.

The actual rates post facto have consistently been lower (far lower) than the Forward rates (rates quoted today for $ that will be delivered say 3, 6 months later).

The first one is determined based on the difference in inflation rates and the second one based on difference in nominal interest rates. If the Real Interest Rates are deducted from nominal, then the movement in both should be determined by difference in inflation. This should hold but for changes in outlook and situational factors and the policy induced difference in Real interest rates.

The persistence of actual rate being way less than Forward rate represents a serious imbalance and causes plenty of problems in domestic competitiveness, flow of foreign currency, investment absorptive capacity, etc. For example, if apples (representative of a basket of goods) are selling at Rs 50 in India and $1 overseas, then exchange rate should be ideally 1$ = Rs 50. Say, next year Indian apples have suffered an inflation of 10 per cent and have gone up to Rs 55. But apples overseas have suffered an inflation of 2 per cent and gone up to $1.02. Then the exchange rate should be Rs 55/1.02 = 53.93. But if the exchange rate is kept at say Rs 51, then the Indian exporter will get 1.02$ X 51 = 52.02 Rs /apple while he is able to get Rs 55 selling it domestically. Why would he export? To overcome this, we should allow the Re to correct. This will happen if we match the $ supplies into India with its net imports

Contours of a new framework agreement 

The framework agreement between the Government and RBI should cover all the essential variables not just one or two in isolation. Such an agreement should cover the following.

Limits on Forex Inflows: The inflows should be calibrated to match the absorptive capacity of the economy and its investment needs.  While Capital account convertibility can remain, RBI has to limit the quantum either at total levels or under each major sources of inflow. Reserves are a costly loss making insurance asset (much like Gold in individuals’ hands) whose cost are far more than the difference between interest earned and paid. It has effect on the real economy. The limits can be +/- 1-2% of what is required to plug the CAD or 6 months imports +/- 2 weeks.

Maintenance of Competitiveness: Competitiveness comprises two elements – the physical and the currency. Physical competitiveness comes from technology, scale, skills, IPRs, and natural resource endowments over which neither RBI nor Government may have control. Currency needs to stay competitive which can be achieved only if it floats freely to reflect the inflation differential.

Forex rates: RBI should be mandated to maintain the REER values within 2/3% of Re’s REER value after correcting the massive divergence now on a one-time basis.

Recalibrating REER Values: Again instead of using the general inflation numbers of the countries it should be the inflation of major input costs (including interest costs) of goods and services traded between India and its major trading partners. This basket may keep changing but there are real dangers of monolithic baskets or even currencies as a whole which are governed by many factors other than what determines competitiveness.

Real interest rates – Real interest rates should be mandated to be within 5-10 bps spread over interest rates in competing countries and those investing into India. High real interest rates and overvalued currency may encourage debt flows more than investments in real assets and FDIs.

Inflation: Divergence between estimated actuals and realized actuals after the end of period is difficult to control even for items like Forex rates where almost all participants are educated, trained and hence rational. It becomes even more hazardous in inflationary expectation. It’s time we move on to inflation targets for 3-4 major groups. Food inflation is far more politically sensitive and socially damaging than perhaps white goods or real estate.

Stability of Laws:  The last 4-5 years have seen sudden sharp changes in rules governing provisioning, NPAs, default status, etc. and levels of support to distressed assets even those which are clean but facing stretched cash flows. Changes should factor in reasonable adjustment period.

Quid Pro Quo

If these are corrected, governments should undertake to do the following:

  • To stay within the 3-4% fiscal deficit targets,
  • To smoothen MSP increases based on fundamentals rather than subject to political whims and fancies,
  • To curtail interest declared on mandated savings like PF, PPF etc.,and
  • Not to announce arbitrary minimum wages.

The current economic impasse is arising out of highly overvalued currency, uncompetitive real interest rates, inflows far in excess of absorptive capacity and inflation which looks more western and 1st world’s. The entire burden of causing growth and employment hence falls on the elected Government which has to substitute for the private sector which has been rendered uncompetitive due to these imbalances.

A comprehensive agreement on the above lines would go very far in kick starting growth and employment once again.

Flexibility and Agility are Virtues

Ironically almost a century ago, as the noted economist Irving Fisher in his The Money Illusion quotes Reginald McKenna, Chancellor of Ex-chequer UK as follows: “Since the War, central bank reforms have been instituted in Albania, Austria, Chile, Colombia, Germany, Hungary, …India, Russia, South Africa. In all these countries, except India, not one central bank has copied the Bank Act of England; but with that exception, all have adopted some system which is similar to the Federal Reserve Act” which provides for an ‘elastic currency’… the greater elasticity of the Federal Reserve System (is) the main reason for the higher prosperity of America”.

What was true then of America is true today of China which has proved far more nimble footed and what was true of Bank of England is true of RBI, which treats cast in stone monolithic approach as a virtue.

(The writer is the author of Making Growth Happen in India, Sage Publications).

 

Time to shed excessive fixation over inflationary expectation in Monetary Policy Making

The Last 3-4 years inflation control has become the dominant theme of our monetary policy making with just a lip service to growth and even lesser concern for what is needed most by the democracy – employment. Inflationary expectations have become the mascot of inflation and taming it has become a near exclusive fixation. the current approach fails to incorprate lessons from the recent advances in behavioural economics
Inflationary expectations have stayed stubborn and unrelenting at 8-10% even while CPI inflation has been has been drifting downwards to around 3-4% for several months.
There are some fundamental issues with expectations of individuals.
Firstly, do retail consumers (unlike equity investors) from whom data is gathered for consumer inflationary expectations have sufficient information and expertise to predict inflation even if they are the ones who are affected? People dislike risks and as Daniel Kahneman theorises people dislike losses twice as much as they like profits. There is hence a tendency to overestimate risks and the losses especially the non insurable ones. Even RBI itself has been consistently overestimating inflation.
Secondly, mind comprehends or estimates prices more based on purchase cycle. For example, a vegetable or fruit purchaser might think or worry about what will it be in the next two weeks. But it will be futile to ask him for an estimate of prices 26 or 48 weeks hence. RBI data gathering does not reckon the purchase cycle.
Thirdly, the nature of human mathematical comprehension itself and translation thereof into annual numbers. Even if they knew rightly that the weekly inflation of two different items are 0.2% and 0.5%, they will most likely come up with annual numbers in the region of 6-10% (instead of 11-30%). RBI’s data on various class wise inflation expectation figures reveal how the expectations are in a significantly narrower band than the experience of the preceding few weeks or months which should have had a significant influence on their expectations. Vegetables prices vary by as much as 40% between March and September (RBI’s Mint Street memo 19), yet this is never captured in the expectations reported which stays flat at 8-10% for most of the times.
How much do expectations drive actual behaviour.
This is the most crucial question that would govern the success or failure of the current approach. Unless it can be demonstrated that people’s behaviour (in direction as well as quantum) is consistent with their inflationary expectation using it will be as perilous as a trap shooter shooting before the bell and hoping that somehow the clay pigeon will show up where the shotshell goes.
How much inflationary expectations will affect consumers buying behaviour depends on several factors like the life cycle of the product itself, per transaction costs, costs of advancing or postponing buying decision and the alternative (even if short term) investment avenues and cost of funds (borrowing costs).
A 15% annual inflationary expectation in real estate might make many to advance their purchase of house sooner than later more so if the financing costs are lower and perhaps even reallocate from other items to beat the market. But the same inflation expectations for petrol and diesel prices (roughly 1.12% on monthly cycle basis) may not make a car or 2 wheeler owner to tank up on empty cans to cover his next purchase. The same rate (0.264% on weekly cumulation basis) would not make anyone to stock up on vegetables especially given the cost of preservation and possible deterioration.
The House owner will most definitely compare his cost of borrowing with his expected price increase in house prices to make his purchase decision. But for articles of daily consumption or even white goods the household consumers are unlikely to be swayed by inflations of the range one is talking of in India. This can be gauged by the discount quantum announced during festive seasons or season end sales in India – upwards of 15-20% of sale and in some items 40% or one free for every one purchased and so on. One does not hear of 1-2% off on discount sales open only for 1-2 days (a 2% discount ending in 2 days translates to a cumulative 3500% p.a.) even for ‘definite to be purchased’ articles of consumption like clothing, household supplies etc. It does not have any impact. Even the pensioners may not be influenced to stock up even when their savings may be earning just 6-8% annual interest rates.
Unless inflationary expectations translate to rational choices by consumers, the current approach will on most occasions result on excessive action. And as RBI’s data clearly proves that as far as India is concerned, inflationary expectations are not necessarily rational expectations.
Only when inflation becomes high (say 20-25% for India) and the interest rates are way lower in comparison or in a hyper inflation (like in Venezuela now), would people be driven to rush their purchases fuelling the price increase further. The current approach at inflation levels of 4-6% seems like having a foot firmly on the brake pedal as a precautionary measure while driving at 1 kmph. Actually many end products in agri and manufacturing sector are crying for a better inflation to neutralise their cost increases.
A case for differentiated approach
There is good case for junking our inflation control focus of monetary policy making. If our economists have faith in their own icon, Philips (after whom the curve linking inflation and unemployment is named), even in short run they would be forced to conceed that a low inflation is a leading likely cause of the current unemployment crisis. We can just use the last 2 months or quarters inflation to decide what to do and should it be necessary convene the review meetings at closer intervals whenever necessary.
Rather than a single objective whatever the inflation, we should move a into differentiated approach depending on levels of inflation. Upto 4-6% inflation we should focus on job creation, between 5-8% may be on growth and employment and thereafter inflation control can take primacy.
Our industrial capacity utilisation is stuck at about 75% for a long time now. The lowest hanging fruit to be harvested for employment and growth is to put the unutilised 25% to use. It would take a bold approach to identify the more viable ones amongst these and provide them with 4-6% working capital, which could make them chugging again. A growth of an additional 2% will deliver more goods and services to the consumers and tame inflation and create employment far better. But such a sensible approach would be blasphemous to our orthodox theorists.

Income Transfers – is it the most effective solution.

Link to Businessline Article: https://www.thehindubusinessline.com/opinion/are-unconditional-cash-transfers-desirable/article26762792.ece

Just recently Congress has announced its promise of income transfer of Rs 72,000 for the poorest 5 cr families costing the Central Government Rs 360,000 cr., potentially becoming bigger than our Defence Budget.

One side of evaluation is the feasibility of mopping this amount without fiscal stress. But the other side to look at is whether this is the most optimal solution to bring about the desired impact on the target,  which is what we will focus on.

Inequalities of Income arise from three other forms of inequality (i) inequalities in human capital (levels of health, literacy, skills, etc.), (ii) Inequalities in Opportunities (in education, jobs, etc.), and (iii) inequalities in living conditions.

In the long term, these can be corrected only by better healthcare, education and skilling, creating sustainable jobs and the industrial competitiveness to create jobs, housing and medical infrastructure for poorer sections, etc.

But in the short to medium term (say 3-5 years) the inequalities can be more urgently addressed by ‘redistribution’ of wealth, income, reservations etc.

Thomas Piketty, the renowned French economist classifies the redistributions into two categories – Direct and Fiscal. Some examples of direct redistribution to labour are fixation of minimum wages more than required to compensate for inflation and gains in productivity, prescribing social contributions, ESIC, etc. This increases the cost of labour for employers who may shift to mechanization and thus has a negative fallout in terms of jobs created for the target.

Fiscal transfers tax the richer through income taxes or a wider cross section through indirect taxes like GST. This has the beneficial effect of not increasing direct cost of labour thus not decreasing demand for labour. The scheme in discussion falls in this category. Let’s see the demerits.

Firstly, this form of income transfer is addictive. The amount is too huge to be spent on short term measures without measures to set right the structural defects of human capital inequality. Once started the political system especially in India simply lacks the will to withdraw it even when the purpose is achieved. But more importantly the political system forgets its duty to address the long term issues feeling absolved with quick fixes. We have seen this in reservations, free electricity, etc. A scheme of this magnitude simply cannot ignore the need for balance between the short and the long term. The scheme should spend at least 60-70% in addressing inequality of human capital and the balance in income transfers.

Even if it is not able to take any steps for long term correction, it can make the 60-70% as conditional entitlements like attend adult education and dinner will be free, attend prenatal counselling and child delivery and all inoculations will be free, acquire a skill and one year’s apprenticeship is free, have and use toilets and get one gas refill free, etc. Unconditional entitlements are prone to Chakma Baboon syndrome – any sign of withdrawal can result in attack and even killing – in this case political suicide and hence no political party will dare withdraw.

Secondly in the words of Piketty, ‘the cost of substantial fiscal redistribution would be considerable, because it would decrease the return on investments (for individuals) in human capital and thus decrease the incentives for individuals to make such investments …’. Illustrating, if wages earned by a 8th std pass is Rs 60,000 on average and that of a 12th std pass Rs 90,000 per annum, his family will decide on sending their wards to school based on these incremental returns on investments. However, if Rs 72,000 is guaranteed, the incremental returns to investment upto 8th std and 12th std becomes Rs (-) 12,000 and Rs 18,000 per annum respectively.  If in the neighborhood it is not shameful to be uneducated, the family might conclude why educate anyone upto 8th std to earn Rs 60,000 when he can sit at home and get Rs 72,000. This will save them their investments. This outcome will seriously dent our ability to address the long term issues.

Thirdly, researches on the impact of neighborhood, family status and social settings have led to conclusions like, ’inequality of educational opportunity is reproduced from generation to generation’, ‘students from modest background are less motivated to pursue lengthy courses of study’, ‘(it is) the immediate social environment that inequality inevitably originates’. The surroundings have a huge inertial impact on perpetuation of inequalities and need far greater and immediate attention to get the basics right. Widespread initiatives like sending some bright students to different settings so that they have demonstrative impact, forcibly setting toilets in the poorest 10-15% of families in poor neighborhoods so that it creates peer pressure on others to follow suit, setting up model farms with improved agricultural practices, model houses in slums, etc. should be initiated to tackle this highly underappreciated impediment on equalizing inequality.

To give credit where due, given the labour market conditions (high levels of unemployment), fiscal transfers are a far more effective tool than increments in minimum wages and other mandated payments by employers. Given high possibilities of mechanization, minimum wages would have driven more enterprises away from labour and worsened the problem.

One way perhaps to strike a balance may be to issue equivalent value coupons eligible for exchange in areas we desire them to consume – education, purchase of food, clothing, building materials for housing, use in public toilets, buying medical services, payment of insurance premiums for crops, life, cattle etc.

A succession of poverty band aids starting with loan write offs, educational loan write offs, transfer of Rs 6000 per family and now this Rs 72,000 to the bottom 5 cr people is a clear sign and admission of failure of our reforms to address the concerns of the poorest sections of our society.

Income transfer looks not the most optimal solution at present. Even so, one wishes that if it gets implemented the information does percolate properly and every one of the families take due advantage of it to get out of poverty for sure, without leakages plaguing this initiative as well.

(The writer is author of Making Growth Happen in India)

Contrarian Ways to tackle Agrarian Crisis

https://www.thehindubusinessline.com/opinion/tackling-the-agrarian-crisis-differently/article26501142.ece

Article link in Businessline 11 March 2019

Agrarian crisis is staring on our face and as usual a flood of familiar suggestions have resurfaced. The political responses have been on expected lines.

Fixing MSPs at 50% over costs is as disastrous as it can get. There is no inherent incentive for cutting down the bill on Government or the rest of society. It may be possible in Western societies where 2-10% farmers depend upon the rest 90% but not in India where 50% are in agriculture. The sinking water table without a care, due to free electricity even in the land of five rivers (Punjab) is an example of such a sink hole. On the contrary, when West Bengal used to charge farm electricity same as residential, it held its water table since the farmers used the expensive resource judiciously.

The basic problem is that our agri sector is producing more than the demand, even when its productivity is way below world standards. The Kcal value of just the top 8 food items produced is approx. 2250 just about what an average Indian requires. And we have compromised the soil health massively in the last 4 decades, so the costs are increasing way beyond productivity gains.

The main impediment in tackling the crisis is the wrong formulation of the problem. Instead of seeking to double the farmers ‘gross’ income, we should seek to raise his “net, net income” – net of costs but more importantly net of soil health loss and depreciation. Let’s see how this cab ne achieved.

First the wastes in our cultivation. Our flood irrigation system which has evolved to cut off oxygen to weeds and thus control their sprouting, has had adverse consequences on plant health also. The excess water washes nutrients, costly chemicals and fertilizers along with it, more than half of these never coming in contact with the plant or root aura. These unutilized chemicals have long term consequences on soil quality.

SRI (System of Rice Intensification) farmers who have consistently reported higher yields, have direct- planted or planted single seedlings with gaps of 20-25 cm (instead of clumps) and shunned flood irrigation for just retaining enough moisture and reported 80% savings in seeds besides saving 50% water.

Next the soil health. Excessive chemical application has killed the earthworms so necessary for aeration and microbes and fungus which break down vegetable matter and carbon into essential inputs for plant growth. These chemicals solidify soil causing easy run-offs. Stronger osmotic pressure of the chemical solution outside the root systems promote reverse osmosis causing the water to flow from roots to soil rather than the other way around causing withering and dryness in some crops.

We need to get a lot more humus into our soil to boost its water retention (without run offs) to achieve the above and enable stronger roots that can to go deeper and wider and sponge more nutrients besides being naturally more disease resistant.

We need to rotate the crops judiciously with nitrogen fixing legumes/plants, so that the artificial life support of chemicals get replaced with natural manures and supplements in a far more balanced way.

Sir Howard the author of the Indore experiment, had demonstrated that with just the organic material available within the village – the foliage, crop residues, and animal residues,  it is possible to generate all the humus and compost and within it all the chemical required in a more balanced manner at much lesser costs. It might require some reinventing the natural and traditional methods and some re-training.

Trapping more incomes within village ecosystem: The Indore experiment cited above reported that a pair of oxen can help generate 1350 cft of compost i.e approximately 27 tons of manure containing a balanced mixture of essential chemical ingredients. The market price of equivalent weight of Urea is about Rs 1.45 lac. Even if one were to offset the cost of animal keep and downscale the value, it would still leave a net Rs 30-40,000 of commercial value in the hands of the farmer and village community. Instead, villagers are driving away these to graze unyoked and spending a fortune in ‘importing’ costly fertilizers. A better balance should be attempted.

Rice production is reported to be contributing nearly 15% of world’s methane emission annually. Long term research should focus on harvesting this thinly spread greenhouse gas like we have done with Sunlight. It is also possible to sequester carbon by traditional methods as modern agriculture is one of the biggest contributory to carbon emission.

If these incomes are trapped within the village ecosystem it could lead to better secondary cycle of incomes and enable our villages to make more investments in housing, electricity, healthcare and education, the other social necessities.

Employment potential: Adoption of natural or semi traditional methods of farming like manual composting and weed control, controlled water charge, focused pest control, recharge of crop residues are reported by Joel Bourne in his book The End of Plenty to absorb 27% higher labour. That may be a huge boon by itself for India which desperately needs to create employment.

‘Open sourcing’ research: The current system of research excessively serves only certain sections or links to the compromise of overall health. It is focused on maximizing chemical or insecticide sales far beyond optimal levels. So much so that insecticide companies do not even train the applicators on optimal volumes or safe methods of application. Today, more people may be dying out of their harmful effects besides those who consume it as poison, than out of farm loan distress.

There is a compelling case for ‘open sourcing’ all agricultural and allied research even if necessary by Government setting up more facilities under its control as well as opening up trade at least in commodities where we have surplus.

In conclusion, it is possible to more than double the net farm incomes just with better seeds and package of farm practices, cutting down heavily on the artificial ‘boosters’ even while preserving or promoting soil health.

RCEP can spell RIP for domestic manufacturing jobs

https://www.financialexpress.com/opinion/opening-up-manufacturing-without-proper-employment-impact-assessment-might-prove-disastrous/1486932/

No one can deny that overall there are net gains from free trade (FT). If the most efficient producers are provided access without artificial restrictions (political or geographical boundaries) obviously it would optimize the costs for a given level of consumption.

But how those gains are distributed is an unsettled question. We can have examples of countries losing out due to FT and others gaining at their expense. It is not even difficult to construct examples of just one country garnering all the gains and all the others losing.

Its also possible that the gainer(s) gain far more than the gains from free trade efficiencies at the expense of others (kind of loss imposition on losers). Unless one is careful about what to negotiate/avoid and does homework properly, one may be a heavy loser. Lets see an illustration.

Illustration

The illustration seeks to break up the supply curve in the standard demand supply analysis of micro economics. The supplying units are arranged from the most efficient to least efficient from left to right. Efficiency is measured by how low the total variable cost is. The thick ridge line running over the top of various bars representing individual units comprises the supply curve. Those to the left of where the Demand curve meets the Supply curve gets to supply the market.  Those to the right will incur a cash loss since the market price is less than their variable cost.

The illustration studies the impact of removal of import duties after FTAs. After removal of import duties, the supply curve accommodates more overseas players to the left and push out some domestic suppliers to the right of equilibrium pricing and hence face closure.

The net impact (difference between before and after scenarios) in the illustration is as follows:

  • The Government has lost whatever Import duties it was getting from the Korean (for example) suppliers who were already competitive suppliers in the market. The entire amount would have accrued to the Korean suppliers,
  • The domestic consumers have benefitted from a price reduction of less than 1%. This is most likely from better efficiencies of the overseas suppliers.
  • There is a net loss in domestic employment (loss of 9% down from 139 to 127 in the illustration).This would have either resulted in better employment overseas or better capacity utilization for them.

This kind of relatively flat demand or supply curves prevail in commodity industries where consumers don’t pay much premiums for brand and supply efficiencies come from factor cost differences, scale economies, cheap labour, patents, etc.

Net loss in employment.

Larger and concentration of capacities enabled by FT does facilitate mechanization and result in net loss of employment as empirically observed. These net losses in employment have also to be distributed and one can end up with a disproportionate share of this unemployment as in the above case where the host country ends up with all the employment loss.

Ineffectiveness of Revealed Comparative Advantage

One of the methods oft-used by trade economists to identify industries with export or import competitiveness is the Revealed Comparative Advantage (RCA) and its variants. Essentially this method calculates the ratio of (i) % of a particular commodity in a country’s exports to (ii) the % of global exports of the commodity in world exports. If the ratio is more than 1, then the country is supposedly export competitive. Instead of global %, one may use specific country %s, regional %s, or host country’s %s, to identify export competitiveness or import vulnerabilities.

But it is terribly reliant on the past like using KL Rahul’s yesteryears averages to play him in todays matches. What is important is the current competitiveness in an ever dynamic world, where the steep price fluctuations in some key inputs like oil, metals, interest rates, etc. can vastly change the fates of several industry players’ competitiveness.

As can be seen from the illustration the units around the equilibrium price – may be 20-30% on either side would largely decide the gains or losses from trade. Units which are highly competitive (leftmost) or least competitive (rightmost ones) will hardly matter. For example, ASEAN units despite a duty reduction do not enter domestic market. There may not be much point in negotiating access in such a commodity if we are in a similar situation.

Likely effects of Regional Comprehensive Economic Partnership (RCEP)     

This kind of analysis should be done for both commodities where we have some basic strengths and where we would like to invite competition. Using elasticities alone may not suffice as so much depends on capacities of individual players around the equilibrium price. ASEAN FTA has not resulted in much gain or loss over the last 5 years it has been in full operation. But China is a different player altogether.

Many Chinese commodity players have huge capacities – in select cases a single unit or player have enough capacities to supply the entire Indian market. If an import facilitating measure or cut in duties make them competitive in domestic industry, then the whole domestic manufacturing can get wiped out resulting in loss of domestic employment.

India’s strength in its low cost labour, but largely untrained and low skilled. In most manufacturing units the wages account for 8-12% and dwindling by the day. Even a 30-40% cheaper labour translates to only a 3-5% overall advantage which is not even sufficient to counter our unreasonably high real interest rates. But where wages constitutes 40-50% like in many services, IT, research, design, etc. a 30-40% cheaper labour can give 10-20% overall advantage. These are also less capital and machine intensive and interest rates are less impactful.

India’s homework so far in negotiating trade agreements has not been stellar. Opening up our manufacturing without proper employment impact assessment might prove disastrous with RCEP. Even if services are negotiated well, it will open up opportunities for higher skilled but the low skilled and labour which are newly transferred from agriculture and rural areas may be left in the lurch.

Illustration:  Before and After FTA – impact of duty reduction

RCEP jpeg

In case the picture is not clear, you may kindly open XL file from the link below

RCEP

Perils of Overtaking Investments

By V Kumaraswamy

There are severe risks attached to investments that are overtaking in nature, even while temptations to make them are high. This is an area that justifies market intervention by the government in the larger societal interest.

An easy-to-understand example is Jio’s launch, which does not introduce a new service or previously unknown product, but essentially an enhancement or more cost-effective solution to an existing demand. It is mostly a differentiated packaging of what was available through Airtel, Idea, Vodafone, etc.
The current wave of investments in retailing, some banking services, building airports in nearby areas, building parallel roadways or expressways are other examples. Jio’s financial engineering and data plans makes it more attractive for customers to switch. It is most likely commercially feasible: Perhaps by incorporating the lessons and piggybacking on other investments, it will generate better margins than previously seen by others—but these are for Reliance.

The problems with such investments are the wide divergence between private returns and net incremental returns at the societal level. Sure, it will attract new customers who couldn’t afford cellphones earlier and, to that extent, the incremental value-addition from investments will be equal at both private and societal levels.

But for customers who switch from other service providers, the two will vary vastly. Some customers may switch for better quality or range of service and, hopefully, their bills will also increase. In such a case, the net difference between their earlier bills and the current may count for net increase in value-addition at societal level (GDP increase). But for customers switching purely for better prices, even measurement becomes an issue.

In all the above cases, the private player will enjoy the full benefits of sales. However, the net value-addition for the sector as a whole after deducting the decrease in sales of other existing players is what the society gets as incremental value-addition. This will be significantly lower than new private player’s income depending upon the degree of substitution and customer switches. While the net value-addition is so constrained, in investments no such adjustments are possible. The returns on investments at the individual corporate level and at the societal level will differ, with the societal return on investments most likely to be far lower. While the former will be higher than the prevailing interest rates (otherwise the concerned corporate won’t be investing in the venture), it will be difficult to be ensure the same at the country level.

This subpar (at country level) investments will sure create problems for lending banks and equity investors. The key question is: Should the society’s savings be invested in such ventures?

If a different division of Airtel had come up with an exact replica of Reliance (even without Reliance coming out with its own), would its board approve it in the larger interest of customers and risk writing off huge standing assets on the ground? Doubtful.

And even where innovation was distinctly better; GE’s Edison fought tooth and nail for continuation of DC current over AC current supply systems being attempted by its competitors, largely to protect its standing investments rather than due to any conviction that DC was less risky for consumers. Many consumer products and durables also have such examples, but they do not create the same societal inefficiencies like in infrastructure or capital-intensive industries.

Precautions
While consumers should have choice on at least cost, emerging economies can ill-afford such investments. There will be many investments into newer sectors that can deliver far superior returns at national level. We should ideally be pursuing those, rather than ‘overtaking investments’. It is easy for emerging economies to fall into the trap of investing in ventures that individually look attractive, but do not deliver much GDP, growth or employment on a net incremental basis since tested alternatives are readily available elsewhere.

Sure, in a free-market economy, there can’t be any legislations to bar private players from investing in such sectors. But those investments could be mandated to bring in equity to support such investments since the risk is higher due to uncertainties in market share capture, new investments being able to reach planned customer switches, etc. The lending banks could be mandated to insist on a far greater proportion of equity in such ventures. This could be based on net social returns calculations. Banks may also be empowered to require the existing players to bring in more equity on the advent of such investments into the related sector. This may, in some cases, force the existing ones to seek exit by selling out to the potential newcomer. The Insolvency and Bankruptcy Code at least makes exits faster and reduces idling investments.

A certain level of such investments is inevitable or perhaps even necessary for continuous upgrade of services. The sector regulator or banking regulator could perhaps prescribe minimum social return criteria for lending public money in such ventures. Alternatively, the proportion or quantum of funds that can stay invested in such ventures may also be specified.