Friday, December 02, 2016

Demonetisation and interest rates

Demonetisation was widely expected to bring about a sharp fall in lending rates on account of the surge in deposits in the system. The RBI's move to impound 100 per cent of incremental deposits starting from September 16 to November 11 has raised doubts over such a decline.

The RBI has said it will review its decision on December 9 (when it announces its quarterly monetary policy). The removal of currency is hugely deflationary and the economy could do with a monetary stimulus. However, we're seeing an exit of FIIs from the debt market and the currency has fallen. Given the knock to GDP and earnings and a forecast increase in the Fed rate mid-December, the RBI will have to be careful about dropping the policy rate. It would be a surprise if it cut the rate by 50 basis points as analysts had forecast and it would not surprise me if held firm.

Over a long period, however, we can expect demonetisation to usher in lower rates. Various other benefits will also kick in, notably greater financial inclusion and a reduced use of cash. I cannot resist noting how many respected bankers are upbeat about the  move in a way in which economists are not.

My guess is that more measures to attack black money will be forthcoming after December 31. What's being attempted is a paradigm shift- or, if you like, Big Bang reform. This is what economists have long been clamouring for but they couldn't have imagined it would happen this way.

More in my article in the Hindu, Dashed expectations.

Tuesday, November 22, 2016

Larry Summers thinks costs of demonetisation outweigh benefits

Larry Summers, the well-known economist and former US Treasury secretary, thinks that India's demonetisation  drive is ill-judged. It penalises honest users of cash without being able to flush out black money in a meaningful way. And the costs imposed on the economy may outweigh the benefits. In the American and European context, he argues that the right way forward is to stop fresh issue of high denomination notes, not declaring existing high denomination notes illegal:
There are also questions of equity and efficacy. We strongly suspect that those with the largest amount of ill-gotten gain do not hold their wealth in cash but instead have long since converted it into foreign exchange, gold, bitcoin or other store of value. So it is petty fortunes, not the hugest and most problematic ones, that are being targeted.
Without new measures to combat corruption, we doubt that these currency reforms will have lasting benefits. Corruption will continue, albeit with slightly different arrangements.
Nothing in the Indian experience gives us pause in saying that no more large notes should be created in the United States, Europe, and around the world. We were not enthusiastic previously about the idea of withdrawing existing notes from circulation because we judged the costs to exceed the benefits. The ongoing chaos in India and the resulting loss of trust in government fortifies this judgement.

Friday, November 18, 2016

Trump presidency and its economic impact

I am not persuaded that Trump as president spells disaster for the economy, as his critics would like us to believe.

The betting now is that the extreme proposals on protectionism and regulation won't happen. The tax cuts and spending on infrastructure will happen. I also think that most commentators have not given enough importance to the significance of his intention to revive detente with Russia. We've had a  revival of the Cold War in recent years and it's been threatening to get hot of late with the Americans siding the rebels in Syria and NATO's big push towards Russian borders. The peace dividend of a foreign policy could be very considerable and is something to look forward to.

Now, why would liberal commentators want to overlook something as significant as that?

My piece in today's BS on the subject:



Trump and tragedy? Not quite

In early November, a group of 370 economists, including eight Nobel Laureates, signed a letter that called Mr Trump a “dangerous, destructive choice for the country”. As the stock markets plunged ahead of Donald Trump’s victory in the US presidential polls, Paul Krugman wrote, “If the question is when markets will recover, a first-pass answer is never….we are very probably looking at a global recession, with no end in sight.”

Mr Krugman has already been proved wrong in respect of his first forecast. Following Mr Trump’s victory, the Dow Jones Industrial Average recorded its best weekly performance since 2011 and the S&P 500 its best since 2013.  Mr Krugman– and many others in the economics fraternity- could be proved wrong on his second forecast as well. The pundits, who failed to grasp the scale of Mr Trump’s electoral appeal, may turn out to have been prejudiced in respect of his economic agenda too.  

Mr Trump’s economic agenda is a mixed bag. His detractors have focused resolutely on his anti-globalisation stance while ignoring significant positives. The potentially biggest positive is not even part of his economic agenda. It arises from his resolve to rewrite US foreign policy: a reduction in geo-political risks and its economic benefits if he is able to follow through on his proposed rapprochement with Russia. 

Mr Trump’s campaign promise to change the rules on trade and immigration is a legitimate cause for worry. He has threatened to withdraw from trade agreements and to scrap ones under discussion. He has said that he will raise tariffs steeply on Chinese and Mexican imports. He wants to impose tariffs on American companies that relocate jobs overseas. He has also said that he will deport illegal immigrants and clamp down on H1-B visas.

Mr Trump cannot be expected to backtrack entirely on these promises- he has to meet the expectations of his core constituency. But his campaign rhetoric need not translate fully into action. American presidents don’t have a free hand on trade matters, they need to work closely with Congress. The general reckoning now is that pragmatism will prevail.
Tariffs on Chinese imports may be raised, for instance, but not to 45 per cent, as threatened. Some increases may be introduced as anti-dumping duties. Warren Buffett thinks higher tariffs are a bad idea but “I’m not going to say it will cause a recession”. 

Another big area of concern is the promised rollback of regulation. Mr Trump thinks that the thicket of regulations created in recent years is killing American business.  He has said that he will dismantle the Dodd-Frank Act, enacted after the financial crisis. It’s one thing to substitute Dodd- Frank with simpler and more effective regulations as serious economists have urged. It’s quite another not to regulate the financial sector at all- that’s sure to bring on another financial crisis. 

Turn now to the positives in Mr Trump’s agenda. Mr Trump plans to cut both personal and business taxes and steeply increase infrastructure spending. These would amount to the most ambitious fiscal expansion in the US in years. 

And fiscal expansion is just what the doctors – Larry Summers, Paul Krugman, the IMF, the Economist and several others- have ordered. They have all argued that monetary policy can only take us thus far. Low and negative interest rates have failed to deliver growth even as they have increased the risk of financial instability. Fiscal policy will come into its own will happen with a vengeance with Trump as president.

Increased government spending and tax cuts together are inflationary. That would give the Fed the opportunity to raise interest rates- just what it’s been looking to do. Higher rates will position the Fed to respond to a future recession with a cut in rates rather than through unconventional policies such as Quantitative Easing. QE was intended strictly as a response to the extraordinary financial crisis of 2007, it wasn’t meant to last this long.    

Many will carp about the increase in government debt on account of fiscal expansion. But we do know that there’s no better way to lower the debt to GDP ratio than to have strong growth. Mr Trump is a seasoned businessman. He thinks a cut in corporate tax rates will induce US businesses, who have stashed away trillions abroad, to bring these home. He intends to charge a one-time 10 per cent repatriation fee on profits that are brought back. 

It’s Mr Trump’s approach to foreign policy that promises some of the biggest rewards for the world economy. Mr Trump is, perhaps, the first American president since World War II to view Russia as a partner rather than an adversary. He has questioned the need for NATO. He has promised to work closely with Putin in dealing with ISIS in Syria. 

Such a radical change in US foreign policy would be excellent news for the world economy. Not only has the Cold War been revived in recent years, there’s the spectre of a conflagration in the Middle East and elsewhere with all its implications for the world economy. American and European sanctions have hurt Russia and Russian counter-sanctions have hurt the EU. Economic growth remains weak years after the financial crisis. A heightening of geo-political risks is the last thing we need at the moment. 

Mr Trump’s critics lament the possible demise of the liberal economic order. They seem strangely unconcerned about the steady erosion of the international political order that has underwritten global growth and prosperity since World War II. If they see any merit at all in Mr Trump’s proposed reset of foreign policy, they are not showing it.  

Protectionism and a rollback of regulation. Looser fiscal policy and tighter monetary policy.  Defusion of tensions with a Russia and a lowering of geo-political risks. Mr Trump’s agenda might be more attractive but it falls well short of being a disaster. At least he can’t be faulted for not trying something different where the existing policies have disappointed. 

(T T Ram Mohan is  a professor at IIM Ahmedabad. ttr@iima.ac.in)

Demonetisation won't by itself make a difference to black money

I should have provided this link earlier- I was among the first to comment on this subject in BS.

BS has a pay wall for opinion pieces, so here's the text:

Many have called the decision to demonetise ~500 and ~1,000 notes a “surgical strike”. They were, of course, using for best effect an expression that’s the flavour of the moment.
It’s, however, an incorrect characterisation of the government’s intent. A surgical strike is an operation with limited tactical objectives. The intent behind demonetisation is a frontal assault on black money, with a view to eradicating the problem. However, the expression could turn out to be correct in describing the eventual outcome. Demonetisation is a good initiative but, in itself, cannot be expected to make a big difference to black money in the Indian economy.
The scheme is expected to work as follows. It will render useless large amounts of cash held by black money operators. They will have to come forward, put their cash in legitimate channels and get exposed or they would have to simply discard their hoards.
There are several problems with this formulation. First, it assumes that black money is held overwhelmingly in cash. It’s not. Currency in circulation in the Indian economy is about 10 per cent of gross domestic product (GDP) — in the US, it’s about seven per cent. Black money goes into a variety of assets — business assets, real estate, gold, etc.-  and a relatively small proportion is held as cash. The proportion is higher in real estate than in other businesses. Cash is generated from businesses as required using a variety of means such as under-invoicing and over-invoicing, evasion of excise duties, etc.
Secondly, it assumes that the only means available for people to use their black money hoards is to bring them into the open by depositing these in banks. This again is not entirely true. There is a well-developed parallel mechanism for converting black money into white through the use of trusts and bogus companies. Those who have availed of it will tell you how astonishingly smooth and reliable its working is.  
Thirdly, we are assuming that black money operators are seriously at risk if they bring their money out into the open. This may be true of small businesses and self-employed professionals such as doctors and lawyers. Big-time operators, however, will find ways of handling the problem using their contacts with the bureaucracy and the political class. That’s how they have operated all these years. To expect that things will change radically overnight is to repose a degree in faith in the tax and law enforcement authorities that’s not warranted by past experience.
For many who have black money, the immediate effects could be unsettling. They may face temporary losses. However, once the new notes come into use, it will be business as usual. In other words, any destruction of black money that takes place could be a one-off effect. If it becomes difficult to keep more than a certain amount of black money within the economy, more of it will find its way out than before through the hawala route. It will come back as foreign institutional investment (FII)foreign direct investment (FDI) or private equity flows. Unless, there is a significant breakthrough in unearthing black money abroad – and this is still very much work in progress at the moment – the current measures may merely alter the proportion of black money held in India and abroad.
(The fact of the matter is that- pl delete)  Black money flourishes because it is part of the well-established nexus between business and politics. It is the biggest source of finance for elections and a significant source of income for politicians and bureaucrats. It is there because it suits the interests of the principal players in the system — businessmen, <i>netas and <i>babus. Seriously disturbing this equilibrium would call for changes that go well beyond demonetisation.
There will be consequences for the economy in the short-run, mostly negative.  Consumption will be adversely impacted. Stock market volumes can be expected to fall. Real estate activities will be hurt and there could be a fall in prices. The inflation rate can be expected to decline in the short-run because of the impact on aggregate demand.
Again, these will be strictly short-term effects. It is not clear that real estate prices will fall to a lower level even if the proportion of black money used in real estate comes down. Sellers will now have to pay more by way of capital gains taxes and they will factor this into the sales price. This could well offset the impact of lower demand.
Banks will be flush with deposits in the months ahead. But this need not translate into higher growth in credit. Public sector banks, which account for 70 per cent of bank assets, are averse to lending today because of the pile-up of non-performing loans and for want of adequate capital. They are unlikely to step up lending because deposits have gone up. More likely, they could reduce their dependence on bulk deposits and hence their cost of funds.
It’s interesting that the Reserve Bank of India has portrayed the move to remove higher denomination notes as an attempt to check the use of fake notes, not as an assault on black money. That’s perhaps a more accurate way of describing the initiative. It has all the makings of a surgical strike, not so much an all-out war.

More on independent directors

I have a piece in the Wire on independent directors in the context of the Tata ruckus.


Sunday, November 06, 2016

Indian Hotels independent directors' move is a first of sorts

The unanimous support that independent directors of Indian Hotels Ltd have given to Cyrus Mistry is a first of sorts- so far a I can recall- and it adds to the damage done to the Tata group done in recent weeks. The six independent directors said:

After deliberations, the independent directors came to a view that being a listed company, it was imperative for the independent directors to state their views to the investors and public at large, such that those who trade in securities of the company make an informed decision,

Taking into account board assessments and performance evaluations carried out over the years, the independent directors unanimously expressed their full confidence in the chairman, Cyrus Mistry, and praised the steps taken by him in providing strategic direction and leadership to the company.

The independent directors have thus gone against the preferences of the dominant shareholder, an act of defiance that is entirely welcome, given that independent directors in India are widely perceived as chamchas of the promoters, often backing them to the detriment of the interests of minority shareholders.

It would be premature, however, to conclude that this marks the beginning of a trend. For one thing, we do not know how many of the independent directors were appointees of the Tata group and how many were appointees of Mr Mistry. Independent directors need to be independent of both promoters and management (although often the two are the same in Indian companies).

Secondly, I fear that promoters will now become even more circumspect in their choice of independent directors- they will only pick independent directors of whose loyalties they can be entirely certain. Perhaps, we will see more distant relatives and ex-employees as independent directors. The outcome of the Indian Hotels' independent directors could thus be turn out to be quite perverse in the long run. We need radical changes in the process of appointment of independent directors of the sort I have long advocated (see my earlier post on the Tata controversy).

Meanwhile, the blog post of Nirmalya Kumar, the former London Business School professor, who was advising Mr Mistry on strategy and was asked to go along with Mr Mistry, has elicited widespread sympathy.

It's not just the summary removal that is the issue. Prof Kumar joined the Tata group, he did not join Mr Mistry in a personal capacity. It is not that he was implicated in any improper decisions. Is it the contention of the Tata group that when a Chairman or CEO is removed, those around him must leave because they were "close" to him? I know this happens all the time in many places. Somehow, one expected things to be a little different at the Tatas.




Thursday, November 03, 2016

Goodbye to central bank independence?

Central bank independence is an idea that came out of the stagflation in advanced economies of the 1970s. High inflation did not lead to reduced unemployment- the world discovered the truth that the Philipps curve trade-off exists only in the short-run. If you keep boosting money supply for too long, you get only inflation without the associated benefits of reduced unemployment.

So politicians decided they would leave it to central banks to decide monetary policy as a means of imposing overall macroeconomic discipline. Central banks would then no longer underwrite unlimited government borrowings and this was good for the economy.

Now central bank independence is under threat- and it's not on account of politicians, the Economist points out. The problem is the steady decline in interest rates in recent years, culminating in negative interest rates in many countries. Monetary policy no longer appears effective and this undermines the authority of central banks.

Moreover, the tool that some banks have resorted to, Quantitative Easing, which involves massive purchases of government bonds, amounts to the purchase of government debt using newly printed money- precisely what central bank independence was intended to avoid!

At the same time, there's a general sense that fiscal stimulus has a key role to play in the present situation:
Although economists remain broadly in favour of central-bank independence, the amount of new research affirming the importance of stimulatory fiscal policy is growing. The continued economic doldrums are also creating a political opening for more aggressive fiscal action. On August 2nd the Japanese government announced new stimulus measures worth ¥4.6 trillion ($45 billion) this year. Both American presidential contenders have plans that will raise government deficits, and the British government has abandoned its target of balancing the budget by 2020. Low interest rates have emboldened politicians who might otherwise have ignored the calls of frustrated voters for fear of the bond-market vigilantes.

As monetary policy wanes in influence relative to fiscal policy, so will the importance of central banks.

Here in India, we have seen a movement away from the commitment to a 4 per cent inflation target on the part of the RBI. This has at least partly to do with the perception of the political authority that rigidity in respect of the inflation target of 4 per cent was coming in the way of higher economic growth.

Central bank independence is not ordained by the gods. It was a mechanism devised by politicians in response to a particular economic situation. You can count of politicians to reduce its importance in a different economic situation.

Quote of the day


"Ratlike cunning, a plausible manner and a little literary ability".

Qualities of a successful journalist, according to Nicholas Tomalin, a member of the breed. (The Economist, September 20, 2016)

Thursday, October 27, 2016

Cyrus Mistry spat with Tata- a peek into the board room

As many commentators have noted, the sacking of Cyrus Mistry and the angry letter it has elicited from him has done great damage to the Tata brand. If the dispute drags out, the damage will be that much greater. Tata shareholders have cause for concern.

So do banks that have exposures to the group. Much of this exposure rests on the Tata reputation and TCS profit. The problems at the group will cause banks to seriously rethink the sort of name-lending they have been doing. The RBI's Large Exposure Framework is timely in this context: the restrictions on group exposures were long overdue and it's a pity that the regulator is having to require something that bank boards should have done on their own by way of prudent risk management.

One particular item in Mistry's letter stands out and it had me rubbing my eyes in disbelief. Let me reproduce that portion:
The trust nominated directors, who I would assume would use their own independent judgment and discharge their fiduciary duties, were reduced to mere postmen. As an example, once, the trust directors (Nitin Nohria and Vijay Singh) had to leave a Tata Sons board meeting in progress for almost an hour, keeping the rest of the board waiting, in order to obtain instructions from Mr Tata. Such a work pattern has also created the added risk of contravening insider trading regulations and exposed the Trust, apart from exposing the trustees to potential tax liabilities.
This is incredibleif the staements are indeed correct. The Dean of Harvard Business School, we are told, excused himself from the board meeting and kept the board waiting for nearly an hour in order to take instructions from Mr Tata, who was not even a member of the Board! Is this what they teach by way of corporate governance at HBS? Is this how independent directors are expected to function- go out and take instructions from the leading shareholder even while a board meeting is in progress? The possible violation of insider trading regulations, to which Mr Mistry refers, makes the disclosure even more lethal. SEBI and the stock exchanges, one hopes, will look into this item closely. If proved right, Prof Nitin Nohria's behaviour might well attract strictures from the regulator and the exchanges. Since some of the listed Tata companies are shareholders in Tata Sons, institutional investors would be within their rights to raise this issue.

One wonders what HBS would make of this matter. This is not the first time that an HBS prof's behaviour has raised questions in the Indian context. In the Satyam Computers scandal, Prof Krishna Palepu, another HBS professor, drew attention as he was found to have earned a tidy amount by way of consulting fee from the company with which he was associated as independent director. As reported in the media, the court dealing with matter issued an order asking him to disgorge around Rs 2.7 crore in excess remuneration paid to him.

Mr Mistry makes a number of other statements that are damaging. He would have liked to discontinue Nano but could not do so because of Mr Tata's attachment to it. He was opposed to the group's entry into aviation. There were dubious transactions in Air Asia.The potential write down in the value of assets of group companies is Rs 118,000 crore. IHCL's investment in the Sea Rock property nearly wiped out its net worth. Tata Capital made a large loan under the advice of one trustee and it has since turned into an NPA. And so on.

The question arises: did Mr Mistry raise these concerns at Tata Sons board meetings and were these concerns duly minuted? Did he express his disapproval of the two independent directors holding up proceedings in order to seek Mr Tata's input? What did the other independent directors have to say on various matters? Were their comments, if any, recorded and minuted? It would be appropriate for SEBI to go through the minutes of the board meetings and take stock. Perhaps SEBI needs to issue guidelines on the minuting of board meetings, an area that needs considerable improvement.

Two thoughts arise. One, if this is the state of affairs at what has been India's most respected corporate brand, what can we expect at other boards?What sort of discussion happens at those places? How well are minority shareholder rights protected?

Two, what do we make of the role and functioning of independent directors. As readers of this blog would know, I have been extremely sceptical about the functioning of boards and independent directors. Most boards are rubber-stamp boards that duly accord their approval to whatever the CEO or Chairman wants done. There's very little dissent, very little questioning. This state of affairs cannot change as long as so-called 'independent' directors are selected by the CEO or the promoter. We need a wide variety of stakeholders to appoint independent directors- institutional investors, banks, minority shareholders, employees and others. In my book, RETHINC, which came out last year, I devote a whole chapter to corporate governance and the functioning of boards.

Alas, there's no sign of genuine reform in the board room.

Monday, October 17, 2016

'Bad bank' won't take us very far

The proposal for a 'bad bank' has been revived (although the chairman of the BBB, Vinod Rai, has been quick to dismiss it).

The idea is to rid the public sector banks (PSBs) of their NPAs so that they can generate interest among potential strategic investors or so that they can be merged with stronger banks without dragging down the latter.

I doubt that the idea will take us very far. A bad bank was conceived originally as a bank-specific entity- it was mean to transfer bad assets of a given bank. The bad bank we are talking about will transfer assets of all or many PSBs. That means having to deal with problems of a different scale altogether.

Next, there's the question of whether the bad bank will be have the government as a majority owner or not. If government is to be the majority owner, then all the problems we have with loan resolution at PSBs will continue. If the private sector is to be the majority owner, setting a price at which NPAs are to be sold will be a major headache.

It's not as if the majority of NPAs have to be liquidated. No, the principal challenge in India is to get stalled projects, which have turned into NPAs, to go through to completion. That requires fresh funding. If government cannot provide funds to the existing PSBs, how is it going to provide funds for a government-owned bad bank?

Moreover, the sale of NPAs will be a time-consuming process. The interest burden will mount. Projects which can be made viable today will cease to be viable tomorrow. There's the real danger that large amounts of infrastructure investment will go down the drain. A generalised bad bank for all NPAs seems just a bad idea.

Perhaps, we could attempt something on a small scale. We could transfer some project-specific or borrower-specific assets lying with various banks to a bad bank and see whether resolution can be expedited. In general, however, it's best for the banks to resolve the problem through appropriate restructuring and waivers, supported by government funding.

There's one thing about bad loan resolution we need to be clear about. The most enduring way to get out of an NPA mess is for economic growth to revive. From that perspective, the interest rate cut we saw in the last monetary policy and the expected cuts down the road are the best solutions. The interst rate cuts will revive the financial position of many borrowers and it will help recapitalise banks by boosting the capital gains on their securities portfolio.

Loan resolution will, of course,be necessary but it will be easier to handle once economic growth picks up.

More in my recent article in the Hindu, Why a bad bank is tricky