What explains RBI's surprise rate cut?

The RBI's rate cut of 50 basis points was a huge surprise to everybody. I would have thought the market reaction would be ecstatic. It hasn't quite been that although the market indices have risen. I argued for a 50 bp cut in an article in the Hindu (Hemmed in by the safety net) on September 28 but did not expect the RBI to oblige.

So, what caused the RBI governor to change his mind?

Many analysts point to the global economy, the inflation rate being within the 6% target for January 2016 and the downward revision in the growth rate for India to 7.4%. And yet, none of these was seen as influencing the RBI in the run-up to the budget. It's also hard to buy the contention that the RBI has tilted in favour of growth: the governor is sticking to the glide path for inflation and is setting his sights on bringing inflation down to 5% by 2017. That being the case, the RBI would have been more comfortable delivering a cut of just 25 bp. Why a 50 bp cut?

My guess is that the steep cut has to do with the NPA and capital position of public sector banks. The woes of the steel industry have been added to those of the infrastructure sector and there's no let up in pressure on the NPA front. There's only so much additional capital the government can provide. However, banks are holding to excess SLR securities- around 29% of liabilities against the mandated 21.5%. A rate cut boosts the value of these holdings and gives capital gains to banks. This helps them make provisions against growing NPAs. In the process, the rate cut does provide  a stimulus to the economy and especially to retail credit.

If the market response has been somewhat tepid, it could be because it's hard to conclude that this is the beginning of a round of rate cuts. Instead, as the governor mentioned, the RBI has front-loaded rate cuts, delivered these at one go. It's unlikely that there is much more to look forward to in the year ahead, especially if the Fed rate hike comes through.

We need to get growth over 8%. It would have helped if the governor had reiterated his commitment to the 6% target for January 2016 and omitted any mention of a target for 2017. That he did not do so suggests that bringing down inflation further remains the priority.

Reining in megalomaniacal bosses

Power corrupts and absolute power corrupts absolutely. We've all heard Lord Acton's famous dictum. And we have seen it happening all the time, whether in politics or in a corporation. The trillion dollar question is: what do we do about it?

Many, if not most, management gurus think sermonising or indoctrination is the answer. Exhort managers to live up to "values". Train leaders to be  "caring". Tell those at the top that being "selfless' or "service-oriented" is the secret of true leadership. And so on. And how do we do this? Well, by talking about the "lessons in leadership" to be learnt from Gandhi or Mandel. Or the Gita and the Mahabharata.

In other words, the emphasis is on turning people at the top or those headed for the top into evolved souls. The entire leadership industry thrives on this sort of stuff. It's amazing how popular leadership programmes are. I guess that's because they generate a 'feel-good' factor in participants at least for a short while before reality catches up.

It should apparent to the meanest intelligence that this is a load of rubbish. If sermons could have created a better world, we should have had paradise on earth by now. I point out in my recent book, Rethinc: what's broke at today's corporations and how to fix it, that the whole idea that people get corrupted after they get into positions of power is a mistaken one. Would-be leaders have all the hallmarks of corruption before they get into positions of power. Leadership is acquired through the single-minded and ruthless pursuit of self-interest. It's acquired by discarding "values", setting aside compunction or guilt and focusing on the big prize that people get to the top (leaving aside a few exceptions). So, to expect leaders of corporations to be something different, once they assume power, is sheer delusion.

As Schumpeter puts it in a recent column in the Economist, there is a Donald Trump in every leader, meaning that egomania is to be expected at the top. The answer to that is not try to change leaders into something different- that would require some feat of genetic engineering. It is to take it as a given that leaders will have a dark side to their personalities and to create checks and balances that limit the damage they can do.

One common way is to split the post of chairman and CEO (and to make sure it's not the CEO who brings the chairman on board). Another, which I propose in my book, is to have independent directors appointed by different constituents: institutional investors, large lenders, employees, etc. A third is to foster dissent within the organisation by actively rewarding people who speak up. (The CEO may not like this but the board must find ways to do it). I propose the use of prediction markets as a way of letting diverse views influence decisions instead of having the big boss take all of them.

I also think term limits are a great idea. The US, by law, limits presidents to two terms. It doesn't matter how wonderfully a president has performed or how young he is.(Presidents in recent years have faded into retirement even before reaching their sixties). IIMA, by convention, limits the director to one term of five years.

Do not for a moment think that leaders can be changed into wonderfully balanced, compassionate people. Take it as a given that those at the top will tend to abuse their powers. Find ways to limit such abuse.

Central bank independence: India does better than Turkey and Brazil?

Well, that's what an article in the FT claims. Both Turkey and Brazil have inflation targeting as the objective of their central banks, as India does now. But both countries have missed their targets- thanks to political pressures, according to the article:

Recep Tayyip Erdogan, Turkey’s president, has repeatedly tried publicly to bully the central bank into cutting interest rates, calling its governor a “traitor” and evoking the peculiarly paranoid notion of an “interest rate lobby” that was damaging Turkey by demanding high borrowing costs.

In Brazil, the central bank is still part of the finance ministry, and its head is answerable to the president. Its governors are also appointed by the president and have no fixed terms. In last October’s election, Marina Silva, the Brazilian Socialist party candidate, argued strongly that the central bank had done too little to control inflation in an election year because of political pressure from Dilma Rousseff, the president.

In India, in contrast, the author contends, the RBI has managed to get on with its job of containing inflation, thanks to a determined person at the top. So it's best to leave inflation targeting to technocrats free from any political interference.

Well, matters are not that simple. Inflation targeting is not the norm amongst central banks. The Fed does not follow inflation targeting nor does the Bank of England. Secondly, if we even believe in inflation targeting, leaving matters entirely to the RBI is not a great idea. There is always need for an external input. And government nominees are not necessarily handmaidens of the government. Economists nominated by the government have their own reputations to protect. Indeed, one could argue that they are, perhaps, better placed to act independently that some of those inside RBI, as the latter would have their own career ambitions to worry about and have every incentive to stay on the right side of the government.

Lastly, what constitutes 'optimal' or 'threshold' inflation is not easily determined. The RBI has set itself a target of 6% for January 2016. A recent paper in EPW points out that there is a wide range for inflation thresholds, as estimated by various studies. One study, which covered 127 countries in the period 1960-92, found that the inflation threshold is as high as 20% if outliers (those with hyperinflation of over 40%) are excluded from the sample. The EPW paper itself places the threshold at 11% for Asia, 23.5% for Latin America and the Caribbean, and 23.6% for sub-Saharan Africa.

There could be costs - in terms of lost output- to keeping inflation below a threshold if the the threshold is incorrect. Given the difficulties in estimation, there is a good chance that the threshold is indeed incorrect. That's why being fixated on inflation targeting may not be a good idea. Politicians, including those in Turkey and Brazil, may have a point when they complain about the monetary polices of their central banks.

Indradhanush gives Nayak committee report a wide berth

Former Axis Bank CMD P J Nayak thinks the government is not serious about banking reform. He thinks Indradhanush, the plan announced by the finance ministry recently, is inadequate:

Indradhanush is inadequate… While it is not necessary to privatise Indian banks, it will be desirable to do it. It will be greatly helpful if government’s (equity) share in banks comes down to less than 50 per cent. A lot of the unlevel-playing field will immediately disappear....Reforms will begin when the government decides to rollback the laws.” (The Bank Nationalisation Acts of 1969 and 1980, the State Bank of India Act, and SBI (Subsidiary Banks) Act.

One can understand Nayak's disappointment. Indradhanush makes no mention of the Nayak report. There's been some indication that stock options for top management of PSBs is being considered. But the level playing field in terms of compensation that the Nayak committee had urged is nowhere in sight. Perhaps most galling for Nayak, the government has appropriated the agency the committee had suggested for making top appointments at PSBs- Bank Boards Bureau- without embracing the essence of it, namely, that the Bureau should be distanced from government and should entirely comprise professional bankers.

One should not be surprised. Repealing statutes related to public sector banks is quite out of the question in an environment in which the government cannot even get the GST bill passed. Parity in pay between PSBs and private banks will undermine the economics of PSBs. As for making appointments to PSBs, it is unrealistic to expect the government not to want to have a say when the government is accountable to parliament for the PSBs.

Indradhanush does not make radical changes to governance of PSBs. Its centrepiece is infusion of capital into PSBs. Whether the capital infusion is adequate for all banks one is not sure but it is certainly an improvement over their existing situation.

I have a detailed analysis of Indradhanush in my EPW article, Can Indradhanush help revive PSBs' fortunes?

All eyes on the Fed tomorrow

Will she, won't she?

We shall know tomorrow whether Janet Yellen intends to hike interest rates, right  away or in the near ftuure?

Emerging markets face turmoil but some emerging markets think the Fed should go right ahead; at least, it will end the uncertainty they have been facing. On the Fed itself, opinion is divided. Gavyn Davies, writing in the FT, outlines the options:

The first and more likely option is a “hawkish postponement”, under which she explains that the conditions have not quite been met, but that the bulk of the committee believes this will happen by December. I am not sure that would do much to clear the air.
The second is the so-called “one and done” option, under which the FOMC raises rates by 0.25 per cent (or even conceivably by 0.125 per cent), and the “dots” show that no further rate rise is expected in October or December, except by a small handful of hawks.
This option seems to be gaining ground in the public commentary, on the grounds that it would get the bad news out of the way. But the markets know from past experience that they should take the first rate hike seriously as a guide to the Fed’s underlying attitude, and they would probably reprice short rates in 2016 upwards.
A final, more dovish, option — to keep rates unchanged, and also to eliminate the expectation of a rise in December — is probably not one that Ms Yellen could guide through the committee, even if she wanted to do so.

Financing higher education: ideas from the US presidential poll

Tuition fees in the US have doubled in real terms in the past 20 years, partly because universities have felt no compulsion to curb costs. Student debt is soaring. How to make higher education more affordable? The US presidential poll is throwing up interesting ideas, the Economist reports.

Hilary Clinton's solution: Cap repayment of college loans at a maximum of 10% of income over 20 years. Any shortfall in loan repayment made on these terms would be made good by the government. The cost to government is estimated at $350 bn. As for curbing college costs, Clinton would link government subsidies to reduction in college costs.

Another candidate Marco Rubio wants online programmes to be actively promoted. This is easier said than done. The problem is not lack of information on these programmes, it is that online degrees do not have anywhere near the same acceptability in the market as resident programmes. Rubio has a bold proposal for financing of education: opt for equity financing provided by private investors instead of loans from banks. This would link repayments to earning capacity. To ensure that successful students do not overpay, one could limit the tenure over which repayment happens.

The problem with equity financing, as the Economist points out, is that if a candidate should opt for a low-income career after an expensive education, the private investor loses out. Moreover, those who think they will do well in college and thereafter would prefer to have debt finance to equity as repayments are limited.

One thing is clear: simply leaving it to the market to set fees and trying to fund higher education through loans is creating serious problems. In India, we are aping the American model, especially in respect of management education. We need to think again.

Resurgence of the left in UK and US

Political pundits are watching with some astonishment the resurgence of the left in the UK and- of all places- the US.

In the UK, Jeremy Corbyn is positioning himself for the leadership of the Labour party on September 12. That doughty champion of market forces, The Economist, does not approve one bit:

For him no policy is too dog-eared, no intellectual dead-end too futile. Public spending? Yes, please. Higher taxes? Soak the capitalists and the landlords. State ownership? Nationalise the railways and utilities, get the private sector out of public services and reopen the coal mines. If that were the secret of prosperity, Britain would never have fallen apart in the 1970s and Tony Blair would not have won three elections at the head of a modernised centre-left Labour Party.

In the US, Bernie Sanders stands a slender chance of emerging as a shock Democratic candidate. He may end up getting pitted against Donald Trump, the Republican's own shock candidate who leads the ratings. An article in the Economist describes Sanders' broad political position:

A typical Sanders speech resembles a 90-minute sermon on modern America’s ills, delivered in the growling tones of his native Brooklyn. Hunched over a lectern, snowy hair aquiver with emotion, the 73-year-old’s usual targets include the “greed, recklessness and dishonesty” of Wall Street bankers, the malign influence of billionaire political donors, and the “abysmally low” wages that blight the lives of working families. Change will be hard, Mr Sanders warns audiences, and will require a “political revolution”. He is not joking (the senator rarely jokes). His proposals include moving towards a Canadian-style health system with publicly funded care for all, free tuition at public universities and a trillion-dollar infrastructure plan intended to create 13m jobs.

...Mr Sanders detects a chance in 2016 to lead a national uprising, drawing strength from the millions of working Americans who loathe mainstream politicians, news outlets and the economic status quo. Paraphrasing Franklin D. Roosevelt, he told the rally in Boone: “If the Koch brothers and the billionaire class hate my guts, I welcome their hatred.”

The Economist doesn't think that either Corbyn or Sanders can actually emerge as leaders of their respective parties.

BJP leader Varun Gandhi has a comment on this in the Hindu. He ascribes the resurgence to rising inequality. Gandhi's prescriptions for inequality would, perhaps, find easier acceptance in the Congress than in the BJP:

To cut inequality, we need to raise the level of minimum wages, strengthen collective bargaining, and improve employment benefits. Women need equal wages, flexible work environments and better childcare facility. We need better regulation of business, especially for rent-seeking sectors. Climate change requires a systemic response, with enhanced environmental protection.. With new demands for reservation based on economic criteria, the old politics of ethnic, racial and caste based reservation or affirmative programmes will soon die. 

Well, I am not sure the issue is just inequality, although it is an important factor. There is widespread discontent about the economy, for one thing. More importantly, perhaps, a profound dissatisfaction with mainstream candidates and parties and a yearning for something very different. Trump's appeal is precisely on the latter count, although I cannot fathom how he appeals to black voters.

Some of this is reflected in Indian politics as well. Aap undoubtedly has won out because of its anti-establishment orientation. The resistance to reforms reflects a growing realisation that a disproportionate chunk of the economic pie has gone in favour of business and corporate interests.  The BJP's retreat from the Land Bill and its reluctance to privatise government banks are acknowledgements of the realities on the ground. It's hard to think of any party moving decisively to the right in the near future. 

1965 war: a Pakistani view

I read and re-read this assessment of the 1965 war in Pakistan's Dawn newspaper with some amazement. It is scathing in its comments on the handling as well as the outcome of the war on the Pakistani side:

In fact, the war was started when we launched Operation Gibraltar in early July 1965, infiltrating thousands of Pakistani soldiers into India-occupied Kashmir under the assumption that Kashmiris would rise in revolt against the Indian forces. That never happened and within weeks the entire operation had collapsed. Meanwhile, the Indian forces launched a counteroffensive occupying parts of Azad Kashmir.
Subsequently on Aug 30, we launched Operation Grand Slam that was meant to capture the strategic town of Akhnur and to cut off held Kashmir from India. But it was too late. Another disaster happened when halfway through Grand Slam, the command was changed giving more time to the Indians to recoup and gather reinforcements. As a result this operation too ended in a fiasco.

About the Indian offensive on the Lahore front, the writer says:

...the persons most surprised were the president and the army chief when the Indians launched the attack on Sept 6. Ayub was woken up at four in the morning and given the news of Indian advances towards Lahore by an officer of the air force on reconnaissance duty. Ayub telephoned Gen Musa who said he had also heard the news but was waiting for confirmation!

 The author concludes:

Air Marshal Nur Khan, who led the air force, achieving complete superiority over the Indian air force, called it a wrong war that was planned “for self-glory rather than in the national interest”. History has to be put straight so that the mistakes are not repeated.

On the 1967 war, have you come across anything half as self-critical and objective in the Indian media? If the leading newspaper of a country can carry such an article, I would submit that there is something very right about that country. It cannot be a failed state, indeed, it is a country steadfastly battling any descent in that direction.

I have been an admirer of Dawn for many years now. Its liberalism is not confined to India-Pakistan relations. It has a thoroughly modern and reformist view on matters internal to Pakistan as well. Those who want Pakistan to be a vibrant democracy, free from the taint of terrorism, and also want that India and Pakistan should live together in peace must make it a point to read Dawn.

Who's afraid of the Seventh Pay Commission?

The Seventh Pay Commission looms. This is already giving rise to serious apprehensions about the impact on the fisc and negative comments about a government workforce that is said to be overpaid at the lower levels. Here are the standard comments and my responses to these:

i. SPC award will damage the fisc: Total pay of central and state government employees is 5% of GDP. The government projects a pay increase on the average of 16%. This translates into an impact on the fisc of 0.8%. Amortised over five years, the impact is 0.16%- hardly something to get worked up about.

ii. Where is the need for a Pay Commission every 10 years when government employees get DA increases? : Well, over a ten year period, after taking into account DA increases as well the annual increment of 3%, pay typically rises by less than 50%. This is less than the rise in nominal GDP of around 100%. After the Pay Commission hike, we get an increase in 10 years that is slightly below the nominal GDP increase (so pay and allowances as a proportion of GDP have fallen). The increase is way below what happens in the private sector. If the Pay Commission hike were not there, it would become difficult for government to compete for talent at the top, even after taking into account non-pay benefits such as job security, prestige, etc

iii. Government workforce is bloated and needs pruning: It has got bloated in recent years mainly on account of increases in police and paramilitary forces. We need more doctors, teachers, engineers, etc. Pay and allowances as a proportion of total government revenues has been falling by 1% every year. This is not downsizing as conventionally understood- that is, reduction in numbers of personnel. But, in financial terms, it is certainly downsizing. Wages are becoming less and less of a burden on government revenues, which is to be expected when central government revenues grow at 17% and the rise in annual wages is way below that.

The explosion in pay in the private sector is creating huge inequalities in Indian society. Pay in government should be seen as a sort of corrective to private sector excesses. It is not as much of a problem in fiscal terms as it used to be (although you could always argue that savings in wages can be used for other purposes).

It would best to accept periodic pay rises as a given and to focus instead on training and capacity building in the work force. Don't fret about the cost, instead get the best out of the workforce in terms of service delivery.

More in my article in the Hindu, Seventh Pay Commission is no ogre.

Inflation, deflation and Raghuram Rajan

Chief Economic Advisor Arvind Subramaniam thinks the Indian economy may now be in deflation territory. Deflation is a fall in prices. The WPI has been in decline. Subramaniam's remarks are seen as a broad hint to the RBI to cut interest rates.

But trends in WPI have little bearing on the RBI's policies given the monetary policy framework within which the RBI is now operating. In this framework, the focus is resolutely on CPI and the objective is to bring the CPI down to 6% by January 2016.

Those want a rate cut make two arguments. CPI is below 4%, which is below the 6% target, hence there is a compelling case.Two, a cut in the rate will stimulate growth. In a recent speech, Rajan addresses both arguments:

 To take the first argument first:

The statement “Inflation is low, you can now turn to stimulating growth” also perhaps reflects a misunderstanding of how central banking works. Monetary policy works with a lag of 3 to 4 quarters. So in deciding policy today, we need to predict how inflation will look approximately a year ahead. Today’s inflation therefore matters only in informing us about future inflation. However, today’s inflation measured on a year on year basis may be low because there was an unexpected price spurt last year – the so-called base effect.

So we need to take out base effects before we even assess the information from current inflation, something many observers fail to do. Also, there may be many sources of uncertainty that cloud the future inflationary picture and disconnect it from current inflation – the strength and distribution of the monsoon, the extent and persistence of low commodity prices, the effect of external disturbances on the exchange rate, etc. In practice, we use models to project how all this might play out on inflation, and we overlay the models with the subjective assessments that our internal committee and its advisors offer, to ultimately arrive at a policy decision.

Our model based assessments of the inflation path are almost surely going to differ a little from the realization, given that the world is uncertain, but they are our best professional assessments, and we set policy based on those assessments. As information comes in, monetary policy is adjusted – for instance, the substantial disinflation from November 2013 gave us confidence about the persistence of low inflation into the future, allowing us to cut the policy rate three times.

What such an approach rules out is what might best be described as “inflation following policy” that some populist commentators on monetary policy advocate.

In other words, the policy rate is set based, not on past inflation, but on expected inflation. Given that the RBI is committed to an inflation target of 6 per cent and has to explain any failure to meet the target, the tendency will naturally be to err on the side of caution- and any number of indicators can be found in the future to support such caution. The inflation targeting framework thus creates a bias against rate reduction.

As for the second argument, Rajan has this to say:

Modern economic theory suggests there is indeed a short run trade-off between inflation and growth. In layman’s terms, if the central bank cuts the interest rate by 100 basis points today, and banks pass it on, then demand will pick up and we could get stronger growth for a while, especially if economic players are surprised. The stock market may shoot up for a few days. But if the economy is supply constrained, we could quickly see shortages and a sharp rise in inflation. The central bank may then be forced to raise interest rates substantially to offset that temporary growth. The boom and bust will not be good for the economy, and average growth may be lower than if the cut had not taken place. This is why modern economics also says there is no long run trade-off between growth and inflation – the best way for a central bank to ensure sustainable growth is to keep demand close to supply so that inflation is moderate.

This is true when the economy is operating at its full output potential. Today, the Indian economy is not because projects are stalled on the ground, partly for want of funds. Cutting the interest rate impacts the supply side as well, not just the demand side. How? By increasing retained earnings, it improves the debt to equity ratio of companies. Some companies can access debt, some can access more equity. Projects can be completed and supply can increase. Further, the rate cut increases the value of securities held by banks and is a clever way of recapitalising them. With more capital at their disposal, banks are more ready to make loans and take risks. A rate cut thus can have important supply-side effects in the situation we are in.

A cut in the interest, of course, provides a stimulus to demand. it lowers the cost of capital and makes some fresh investment feasible. It stimulates demand for housing from consumers and allows housing stock to sold, making cash flows available to builders. 

Axis Bank: Irena Vittal and conflct of interest

Irena Vittal has quit as independent director on the board of Axis Bank. The reason is said to be that her husband is CEO of Bharti Airtel, which won a license for a payments bank to be set up in partnership with Kotak Bank, a competitor of Axis Bank. There was a perception of conflict of interest in this situation.

The implication seems to be that Vittal was placed in a situation where she could share information about Axis Bank with her husband and this would not be in the interests of Axis Bank. This suggestion has drawn fierce criticism from many who see the suggestion as proof of gender bias, implying that we in India cannot believe that a lady can separate her family life from her professional obligations.

What do we make of this situation? Well, I doubt that anybody would want to cast aspersions on Vittal, a professional of repute. But the point is that it is best to avoid a situation that has potential for conflict of interest. There are lots of competent lady professionals out there. If Axis Bank can find somebody who is not placed in a conflict of interest situation, why not do so?

Of course, you could say that since conflicts of interest are par for the course in boardrooms, why get worked up over this one? One situation is where A sits on B's board and B sits on A's board and they happily scratch each other's backs. Independent directors on most private boards are drawn from the same cosy club of CEOs, retired bureaucrats and chartered accountants. Even if there's no technical conflict of interest, independence is the last thing one would expect from the members of this cosy club.

The central issue in boardroom reform is not conflict of interest but having directors who are capable of acting independently of management or the promoter. I have said this before- and I argue at length in my recent book RETHINC (Random House), that the long-term answer is to have proportional representation on boards, with various constituencies other than the promoter and management - institutional investors, minority shareholders, large lenders, emloyees, etc- also been given the right to appoint independent directors.

Then, we have independent directors answerable to those who have put them there, not 'independent' directors who are beholden to  management or the promoter for their seats and fat fees and who will happily nod their heads to whatever management or the promoter wants done.