Forthcoming budget: pause on fiscal consolidation must continue

Should the FM stick to the target for the fiscal deficit of 3.5% for the coming year or not? A furious debate has been raging for the past several weeks. The balance of advantage, in my view, lies in departing for the target for two purposes: higher investment spending and infusion of capital into banks at a level higher than planned Indradhanush (Rs 25,000 crore).

There are two arguments put forward against such a course. One is that foreign investors will take fright if the deficit ends up, say, 3.7% or 3.8% instead of 3.5%. This is not very persuasive considering that we were supposed to have ended up at a fiscal deficit of 3% way back in 2008. If a departure for so many years has not resulted in investors abandoning India, it's hard to see why they should want to do so when the Indian economy stands out amongst major economies in terms of its growth rate.

The second argument is that there are not really worthwhile investment projects that the government can take up. So, a higher deficit is bound to translate into higher consumption. There are ways of addressing this concern. Let the budget list some high priority projects. It is easier, of course, to put a figure on infusion of capital into public sector banks. Let the FM commit to giving a quarterly report on the investment that is happening in the projects mentioned in the budget. With this sort of transparency, the anxieties of foreign investors can be allayed.

We are staring at deceleration in growth consequent to the problems in the world economy at large. If growth dips below 7% in the coming year, we could face serious problems. Investors would be more inclined to pull out. Banks' NPA woes would mount. The government's fiscal position would worsen. An acceleration in growth, on the other higher, would act as a tonic. It would mitigate banks' problems and it would also create conditions for greater sell-offs of PSUs. The risks to macro-economic stability from a falling growth rate are greater than any risks attaching to a departure from the fiscal consolidation path.

More in my article today in the Hindu, To grow or not to grow.

Crashing bank stocks: no cause for panic

India's public sector bank stocks have crashed following higher provisioning or expected higher provisioning at many banks. The higher provisioning follows directives from the RBI that banks fully recognise NPAs and provide for these.

It is natural for bank shares to drop in value as a result. There could be overshooting here, which again is natural in such situations. But a crash in stock values doesn't signify a crash in banks themselves. As the RBI governor has indicated, a few PSBs may end up with negative net worth but the rest will not. Many PSBs would still be meeting regulatory capital requirements. The RBI governor is right: "scare-mongering" by some in the analyst community is just not on.

However, all banks will have seen erosion in equity. This will undermine their ability to lend and grow. So, having got banks to provide fully for NPAs, it is incumbent on the government to provide enough capital. The RBI governor and the finance minister have indicated that banks will receive enough capital support. But this needs to be backed by solid allocations in the forthcoming budget. We cannot have banks providing for losses and suffering erosion in net worth without their capital position being fortified. The RBI must place in the public domain information about the capital adequacy position at various PSBs after capital infusion is announced or has taken place. This will serve to dispel apprehensions and should result in stock values bouncing back.

The interesting thing is that the panic is confined largely to the financial markets. Ordinary depositors don't seem worried and there's no sign of a run on banks anywhere. This is because depositors know that the government stands behind PSBs. That is one reason why public ownership in banking is good. In times of distress, we do not have depositor panic. Had we had any in the present situation, even the better placed banks would have tipped into bankruptcy.

Incidentally, Indian banks are not the only one facing a rout in the stock markets. Worldwide, bank stocks have plunged, as this story in FT makes clear. At banks such as Deutsche Bank and JP Morgan, attempts have been made to shore up market confidence through purchases (of bonds by Deutsche Bank and of shares by JP Morgan's CEO Jamie Dimon). Nor are Indian banks alone in trading below book value. This is true of a large number of US and European banks today. In a way, bank shares in India reflect the delayed impact on India (and other emerging markets) of the financial crisis.

To expect Indian banks to escape unscathed following this impact is more than a trifle unrealistic. By the same token, talk of mismanagement and bad governance at these banks is hugely overblown. There have been mistakes in lending. However, by and large, PSB stocks' fall reflects their broad exposure to crucial sectors of the Indian economy. If the economy and these sectors suffer, so will bank stocks. Period.

Banks and irrational markets

Guess what's the return on equity at JP Morgan, the superstar of international banking? Nine per cent. That's what many public sector banks in India can boast of at one of the most stressed periods in recent times.

Returns at banks are declining as they increase capital (and hence lower leverage) in response to regulatory requirements. Lower leverage means lower risk. This should translate into a higher P/E multiple which should offset the decline in EPS itself and leave bank prices unchanged at the very least.

An article in FT points out that this is not happening. The markets are not rewarding banks for lowering financial risk. They seem to want the same double-digit returns that banks earned when they enjoyed much higher leverage. Are CEOs of banks not communicating properly with investors? Unlikely. It's just that markets are displaying irrationality:

If social mores were different, an obvious response for most bank chief executives, especially investment bankers, would be: 

“You loved this business when it had equity-to-asset ratios of 2 per cent and a 16 per cent RoE. Why do you hate it now that it has 5 per cent equity to assets and a 9 per cent RoE?”

Take Barclays, criticised since the crash for lacklustre returns. In 2006, at the peak of Bob Diamond’s fame and pre-crisis fortunes as head of Barclays Capital, the UK-based bank made £4.6bn profit on average assets of £950bn — a return on assets of 0.5 per cent. In the first half of last year, Barclays made £2.2bn profit; and the business had average assets of £872bn. The annualised return on assets was almost the same. If Barclays in 2015 had operated with the same gearing, or debt-to-equity ratio, as in 2006, it could have declared a 20 per cent RoE for its core operations, rather than the 11.1 per cent it announced.

Scrap the FRBM Act?

The idea is not as crazy as it sounds. The FRBM Act targets have been missed for so long that one wonders whether it makes sense to stick to it and countenance repeated violations. The original Act wanted the revenue deficit to be reduced to nil bu 2008. This was extended by a year to March 2009. We are in 2016 and the talk is of letting the deficit stay at 3.9%.

Without asking for a repeal of the Act, former RBI governor Bimal Jalan questions the idea of having a specific target. He suggests that it may be a better to have a range within which the government can operate. He also thinks the quality of expenditure needs to be taken into account while judging how large the deficit to be- if public investment is the reason for a larger deficit, we can live with it:

The point I am making is that we need to be clear about whether the FRBM legislation should fix a specific quantitative target in two digits. How does it matter? The more important thing is what is this fiscal deficit representing? In the total amount of fiscal deficit, there are subsidies of different kinds. The administrative expenses are huge in transferring these subsides. Now DBT technology is available. We can expand the network of technological transfers and that would give us plenty of room to expand our investment.

We have to keep in mind two priorities. One is public investment. Two is the use of technology to reduce administrative expenses. Also, the ease of doing business is a very good initiative that the government has announced. This will reduce administrative costs without necessarily reducing administrative staff. 

I would add that we need to keep in mind the debt to GDP ratio. As long as the debt to GDP ratio is reasonable (and here again, we should take into account the international situation at a given point) and has been showing a declining trend- which is true of India- we can accommodate a higher fiscal period for a short period of time. India's debt to GDP ratio (centre plus states ) is below 70%  which looks good compared to the ratios in the US and Europe. And the point about a fiscal deficit rise caused by a rise in public investment is that it will lead to an even higher increase in GDP (through the multiplier) causing the ratio to decline over time.

Growth rate is the politicians' call

In my post a couple of days ago, I wondered whether the political class would settle for the 7% growth rate that the RBI governor posits is consistent with macroeconomic stability. As the Economic Survey points out, growth will be in the range of 7-7.5% not just this year (perhaps, closer to the lower bound) but also in 2016-17. The PM and the FM are committed to raising the growth rate to 8-9%- that is crucial to the BJP winning in 2019. I said that what this means for fiscal and monetary policy is a call the political class must take.

Sanjaya Baru, writing in ET today, echoes my line of thinking. He argues, in effect, that economic objectives are too important to be left to professional economists:

While politicians in power should listen to professional opinion and weigh the pros and cons of a policy recommendation, it is useful to remember that fiscal policy requires political judgement and its implementation entails political management. If economists had all the answers, we would not have so many poorly performing economies in countries with the best-trained economists.
Consider the fact that while the best performing post-World War 2 economies have been Germany, Japan, China and South Korea, no economist from any of these countries (bar one German in 1994) has ever been awarded the Nobel Prize.
Clearly, there is no reason to imagine that imported economists stand on surer ground when it comes to macroeconomic policy than homespun ones. And merely because an economist has been correct on one policy issue (this appears to be a reference to Rajan's famous warning of an impending financial crisis in 2005) does not mean that he would be so on all.

The problem for the PM and the FM is that there is little agreement amongst economists themselves on whether or not we should stray from the fiscal deficit targets laid out in earlier budgets and whether there is a case for monetary loosening or not. The Mid-Year Economic Review, which bears the stamp of the CEA, Arvind Subramanian, suggests that a departure from the target would be justified if the fiscal space so created is used for public investment. On monetary policy, it hints that there may be scope for flexibly interpreting inflation targets and the glide path. Niti Ayog Chairman has weighed in in favour of both fiscal and monetary easing on several occasions. NIFPF director Rathin Roy wrote in BS recently:

The RBI will also need to look afresh at its inflation targeting mechanism. The analytical work on which the current inflation targeting band is based provides no technical justification for the target other than some references to what exists in other countries and what previous committees have recommended. An inflation target of four per cent is secured through interest rate policies that result in average lending rates close to 12 per cent. It is little wonder that investment demand is flat. If the RBI does not have the capacity to lower interest rates consistent with four per cent CPI inflation, then government must re-examine the policy justification for a higher target rate within the two to six per cent band. This is, finally, a political decision and the collapse in nominal growth rates provides a sufficient analytical basis for urgent reconsideration.

Disconnect between the elite and the masses

Democracy is about making the rulers accountable to the ruled. The ruling elite cannot afford to be distanced from the masses as they cannot then get the votes they need to gain power.

That is the theory. In reality, the elite everywhere has been getting distanced from the masses, as Martin Wolf points out in a recent article.  It is this distancing that is reflected in the unexpected popularity that Donald Trump and Bernie Sanders are enjoying in the US. Voters are disenchanted with traditional parties and their leaders and yearn for change- change at any cost.

One important reason for this, Wolf says, is growing inequality in today's societies. Ordinary people see that growth overwhelmingly favours those at the top.They either stay in the same place or lose out. Ideally, such a situation should throw up alternatives to the traditional parties (as happened with Aap in Delhi). But today elections cost serious money and so it's difficult for meaningful challenges to arise. Sullen voters are faced with a choice between Tweedledum and Tweedledee. Over a long period, this should cause an overthrow of the established order. For a variety of reasons, this has not happened. The result is societies in which discontent and even anger are widespread.

Wolf comes up with several prescriptions for restoring the legitimacy of the elite. One is specific to the west, namely, containing mass migration. This is something that ordinary people find unsettling. But closing the borders it not the answer. The causes of the exodus, such as bloodshed in the Middle East, must be squarely addresssed.

His other prescriptions are more universally applicable:

Second, the eurozone needs to embark on a fundamental questioning of its austerity-oriented macroeconomic doctrines. It is appalling that real aggregate demand is substantially lower than in early 2008.

Third, the financial sector needs to be curbed. It is ever clearer that the vast expansion of financial activity has not brought commensurate improvements in economic performance. But it has facilitated an immense transfer of wealth.

Next, capitalism must be kept competitive. We are in a new gilded age in which business exerts great political power. One response is to promote competition ruthlessly. This will require determined action.

Then, taxation must be made fairer. Owners of capital, the most successful managers of capital and some dominant companies enjoy remarkably lightly taxed gains. It is not good enough for business leaders to insist that they are sticking to the law. This is not an adequate definition of ethical behaviour. This view is particularly disingenuous when commercial interests play such a powerful role in shaping those laws.

In addition, the doctrine of shareholder primacy needs to be challenged. Shareholders enjoy the great privilege of limited liability. With their risks capped, their control rights should be practically curbed in favour of those more exposed to the risks in the company, such as long-serving employees. And, finally, the role of money in politics needs to be securely contained.

There is little sign in India of any of these issues is getting serious attention (with the possible exception of competition being actively promoted). 

Rajan's tough messages: will the government buy in?

RBI Governor Raghuram Rajan used the CD Deshmukh memorial lecture end of last month to send out some tough messages on the economy and the banking sector. Some of it is familiar enough but those wanting to know where he stands in relation to major policy questions today would do well to go through the speech.

Growth and inflation: Rajan thinks we need to put stability ahead of growth at this point. Trying to grow at more than 7% through resort to fiscal or monetary stimuli could endanger stability. Higher fiscal deficit and higher borrowings could raise the debt to gdp ratio. Monetary stimulus could lead a to resurgence of inflation.

He thinks neither savers nor businessmen should complain about interest rates. In real terms, savers are better off. And businessmen are seeing profits rise even while revenues fall because input costs are falling even more. This may be true for some businesses but not all (as the governor concedes). The fact, remains, however, that the real interest rate for investors (which would be nominal interest rate adjusted for WPI) is rising because WPI is in negative territory. This does cripple investment, which is the area where we have maximum pain at the moment.

Yes, the international situation is grim. But I doubt that the government can settle for 7% growth for long. Job creation is crucial to the PM's agenda. And 7% growth won't give us the jobs we need. The government may accept a low growth rate in the third year of its tenure. But, in the last two years, it will want to press the accelerator. Then, the stability argument won't wash. What if the international environment remains adverse next year? Will the government forsake monetary and fiscal stimuli? I doubt very much.

Banks and stressed assets: Rajan reiterated the need to clean up banks' balance sheets. This means recognising NPAs in full and providing for them. But this means an erosion in banks' capital. On this, the Governor has an interesting take. He thinks the government may not have to chip in a great deal on top of what it has committed. Other sources (the capital markets?), he thinks, can provide some. Plus, he thinks there are several assets the banks have that the RBI would be willing to count towards regulatory capital provided the banks have met the common equity norms. I am not very sure about this. First, I think the infusion by government will have to greater than the Rs70,000 crore the government has committee to under Indradhanush. Secondly, I don't know how the market will view the other sources of capital that the RBI proposes to include towards regulatory capital. Thirdly, these may suffice to keep the banks afloat but lending will be sluggish unless there is significant infusion from government- remember, you need a buffer of about 5 percentage points over the regulatory minimum if you want banks to take risks with loans.

Bank governance: On this sensitive subject, the Governor has been content with posing several questions. 

....should boards not determine strategy as well as the appointment or renewal of their chief executive? What about their executive directors? Can bank boards have more freedom in choosing these? Can boards be given the freedom to set compensation structures and performance measures for their senior executives, including long term stock options?

He wants PSB board members to be paid better, an incontrovertible proposition. Why they continue to be paid Rs 5000 as sitting fee must rank among the mysteries of government in India.

On a lighter note, the RBI governor refers to a recent scam that involves ripping off gullible individuals. I couldn't help chuckling although it's no laughing matter:

Many of you must have received an email from me saying that the RBI had concluded a pact with the IMF or the British Government to take over the gold found on pirate ships in the sixteenth century, sell it, and give the proceeds to deserving citizens like you. In return for a small transaction fee of ₹ 20,000, the email goes on, I would be happy to transfer the sum of 50 lakh rupees into your bank account. Without pausing to think why I need ₹ 20,000 when I supposedly have ₹ 50 lakhs of your money with me, some of you send ₹ 20,000 as requested into an untraceable account. My office then gets repeated phone calls from you asking what happened when the ₹ 50 lakhs does not show up. The truth is that we are all gullible – no amount of warnings that the Reserve Bank does not ask you for your money helps. The central theorem of financial literacy is “There is no such thing as a free lunch”. In the context of financial investments, it can be restated as “There is no return without risk”. We need to imprint these two statements in everyone’s head and we intend to roll out campaigns to do so.