Privatising Indian banks isn’t easy

 The government promises us a big privatisation initiative. It’s not clear whether this includes the transfer of public sector banks to private control. It may mean just dilution of government stakes in PSBs below 50 per cent.

A proper case for PSB privatisation hasn’t been made. In a recent article    in EPW, I make three points:

i.It isn’t true that PSBs have consistently underperformed private banks. The sharp divergence in performance is post 2010 and is the result of PSBs taking a large exposure to infrastructure and related sectors as part of the government mandate. 

ii.  Dropping government stake below 50 per cent is okay provided government continues to be an active investor. Leaving it to institutional investors to manage PSBs is risky as we are yet to develop a culture of professional managers accountable to institutional investors

iii.Valuation will prove tricky and selling PSBs at today’s distressed prices will evoke accusations of a scam that could paralyse PSBs and the government.

Better now to focus on improving PSB performance under the framework of government ownership. There is a marked improvement of late and we may expect more.

India's economic recovery vindicates government's approach

S&P is the latest forecaster to revise its growth projections for India upwards. It expects FY 21 growth to come in at minus 7.7 per cent compared to minus 9 per cent earlier.

India (is) learning to live with the virus, even though the pandemic is far from defeated. Reported cases have fallen by more than half from peak levels, to about 40,000 per day. The feared resurgence following the recent holiday season has yet to materialize. People are moving around much more, with Google data suggesting mobility in retail locations is 25%-30% below pre-covid levels in recent months. This compares with over 70% below normal in the quarter through June 2020,

The crucial point is that the loss of output potential has been less than feared and consumer demand is also coming back. Many economists had thought that the collapse of demand would result in a large loss of output potential as firms closed and people lost their jobs. They wanted a strong fiscal stimulus that would keep firms and jobs alive. 

The government seems to have reckoned that the solvency of firms was not such a big issue and that liquidity support to tide over the lockdown period would suffice.It has to be said that the government reckoned correctly. As a result, we have a fiscal deficit that is not so large as to warrant a sovereign rating downgrade. 

The learest indication that liquidty support has served the purpose is that loan moratorium and loan restructuring requessts from borrowers have been way below what most analiysts and bankers had expected. As a result, we can be reasonably confident now that the banking sector can ride out the covid crisis. It is the prospect of an early and strong economic recovery and a resilient banking sector that explains the surge in bank stock prices in recent weeks. If the present trends continue,the government deserves credit for a calibrated response to the covid shock. 

More in my BS column, Covid shock: India got its response right. 

FINGER ON THE PULSE T T RAM MOHAN 

Covid shock: India got its response right 

The economic recovery thus far has vindicated the government’s approach to minimising the impact of the pandemic Did the government get its handling of the pandemic right? That is the question many will have on their minds as the Indian economy recovers from what was touted as the “worst crisis of the century”. 

There are two parts to the question. One, was the government right to enforce a nation-wide lockdown last March? Two, having imposed the lockdown, did it take the right steps to minimise the damage to the economy? 

The definitive answer to the first part may not be known for a long time. Almost everything about the virus is up for debate at the moment. Is it transmitted mostly through close personal contact? Does social distancing by law help? Is masking of any great use? Are the tests for the virus reliable? Will vaccines prove effective enough and without significant side effects? What answer you get to these questions depends on which scientists you ask or what research papers you choose to believe.

 The Indian government opted for a complete lockdown last March. It judged that the priority was to limit the spread of the virus until adequate capacity was created in the healthcare system. Armchair commentators are free to contend that the health outcomes would not have been different sans a stringent lockdown. They may say that livelihoods should have got a higher priority than they did. However, most people would agree that no government could have taken the risks involved in such an approach last March. 

It is the answer to the second part that is more contentious. In the initial months of the pandemic, there was a chorus of demands for an extra-strong fiscal response. Former chief economic adviser Arvind Subramanian and economist Devesh Kapur exhorted the government to spend an extra 5 per cent of gross domestic product (GDP). Former Reserve Bank of India governor Raghuram Rajan was of the view that India’s fiscal stimulus was inadequate and the strategy of conserving the fiscal stimulus for a later date was self-defeating. Nobel laureate Abhijit Banerjee urged the government to emulate advanced economies that had resorted to a bigger stimulus. Leading economists based in India echoed these views. 

The Indian government chose not to be guided by this barrage of advice. It has preferred to limit the additional fiscal stimulus for the year in the range of 2-2.5 per cent of GDP. One can discern the considerations that influenced this approach. One, the best way to contain the impact of the pandemic on the economy was to end the full lockdown at the earliest. Two, India’s fiscal position was already difficult. A substantial expansion in the fiscal deficit would have implications for the sovereign rating and for an early return to fiscal consolidation post the pandemic. 

Three, with economic activity on hold, the weakest firms would go to the wall but the majority could survive with enough liquidity support. Four, increasing aggregate demand at a time when supply was severely constrained would not help — cash transfers would be saved, not spent, and spending on infrastructure would remain on paper. Five, a large fiscal stimulus would make it difficult for the RBI to contain inflation within the upper limit of 6 per cent. The RBI’s latest inflation forecast shows that we are perilously close to having an inflation rate of over 6 per cent in three successive quarters, which would be a breach of the RBI’s mandate. Six, domestic and foreign investors could be reassured about the long-term economic outlook by announcing major reforms. 

Events thus far have vindicated the government’s approach. All indicators point to a faster revival in growth than forecast earlier. The contraction in FY 2020-21 Q2 GDP has been lower than expected. The RBI expects growth to turn positive in Q3 itself. It is the banking sector that provides the best proof of the resilience of the Indian economy. Following the lockdown, the RBI announced a three-month moratorium on the servicing of term loans last March. This was extended by another three months up to end August. 

When the moratorium period ended, the RBI announced a policy on restructuring of loans. Pundits saw the moratorium and the loan restructuring as leading up to another mountain of bad loans in the future. The RBI’s Financial Stability Report (July 2020) projected an increase in the ratio of non-performing loans to total loans from 8.5 per cent on March 2020 to 12.5-14.7 per cent by March 2021. 

The outcomes in respect of both, the moratorium and loan restructuring, have taken bankers by surprise. Investment bank Jefferies estimates that moratorium loans accounted for only 31 per cent of all loans in Phase I and 18 per cent in Phase 2. If the prospects were as gloomy as they were made out to be, why did more firms not opt for loan moratorium? Perhaps the gloom was exaggerated by firms and pundits alike? 

Banks expect restructured loans to be 2-3 per cent of the loan bank, way below the 5-6 per cent they had expected when the scheme was announced. Retail borrowers and small and medium enterprises have opted for loan restructuring but not many large firms. Bankers are astonished that even in the hotel sector, which is among the worst hit, not many firms have asked for loan restructuring.

 Analysts say that large firms wish to avoid the stigma that goes with restructured loans. Restructuring is perceived as default by rating agencies and would make it difficult for firms to access the international markets. Some of the better-rated firms are able to access funds at low rates through the commercial paper market and are using these to service their loans. 

These may be a part of the answer. But they cannot explain how so many firms expect to get by without restructuring in the face of a huge shock. The explanation must be that the shock is not as great as feared. In not opting for loan restructuring, firms are signalling that we are over the hump. CRISIL now expects the non-performing loans to total loans ratio to be 11-11.5 per cent, which is below the lower range of the RBI forecast. 

If further proof of the resilience of the Indian economy were needed, look at the inflows of foreign capital. In April-September 2020-21, Foreign Institutional Investor (FII) inflows were $8 billion, compared to $7.2 billion in the same period in the previous year. About half the FII inflows in November are reported to have gone into the banking sector. (Business Standard, December 8). It’s a sure sign that FIIs see the banking sector and the economy reviving strongly. Gross FDI inflows were $40 billion and $36 billion, respectively in the two periods. The pandemic has done little to dampen foreign investor confidence in the Indian economy. 

The government kept its nerve in the face of a massive shock. It chose not to resort to a massive fiscal stimulus. It focused instead of providing liquidity support and easing restrictions on movement in stages. Give credit where it is due. The government got its policy response to the pandemic right.

Prime Minister Chandra Shekhar

 Chandra Shekhar served as PM for seven months between November 1990 to June 1991. He split from the Janata Party and formed the Janata Party (Socialist) as he was never reconciled to V P Singh as PM. His party comprising 64 MPs was propped up by the Congress party headed by Rajiv Gandhi. Rajiv toppled him when he found that Chandra Shekhar would not accommodate his wishes beyond a point and also because he was afraid that Chandra Shekhar, an ex- Congressman with friends across political parties, might win over people from the Congress.

Many people see him as a rank opportunist, a man who had no qualms about sinking the Janata Party in order to satisfy his ambition to become PM. They overlook the fact that Chandra Shekhar did not occupy any government office until he became PM, a remarkable achievement, especially given the fact that Narendra Modi's becoming PM straight after having been CM - and without any experience at the Centre- is today thought remarkable.

Roderick Matthews has produced a sympathetic biography, Chandra Shekhar and the six months that saved India. The title may appear melodramatic but Chandra Shekhar did take the crucial decision to borrow against gold in order to prevent a default on India's external obligations. (It wasn't sale of gold, as many think- India pledged gold to the Union Bank of Switzerland and then to the Bank of England and took foreign currency loans against gold. ). Matthews also makes the point that Chandra Shekhar had to deal with separatist crises in Kashmir, Punjab and Assam  and was successful in putting a lid on the latter two. 

Chandra Shekhar was a member of the Praja Socialist Party (PSP) which had split from the Congress and included the likes of Acharya Narendra Dev, Ashoka Mehta, Jayaprakash Narayan and Rammanohar Lohia. Later, the PSP split, with Lohia and a few other leaders walking out of it. Ashoka Mehta led some of his followers back into the Congress. Chandra Shekhar was one of them. He was noted for his rebellious streak and earned the title of 'Young Turk'. He refused several ministerial offers while in the Congress. It's a measure of his independence that Indira Gandhi chose to throw him in jail during the Emergency.

There's no question that Chandra Shekhar was a man of great talent. He was a gifted speaker- he speech at a Saarc summit when he was PM was made extempore. He once spoke on agricultural policy for one and a half hours without a piece of paper in hand. As PM, he impressed bureaucrats with his capacity for hard work, courtesy, decisiveness, preference for consultation and persuasion in  all matters and his enormous respect for institutions. The BBC called him India's greatest PM since Nehru!

Matthews tells us that Chandra Shekhar  was very clear that the Ayodhya dispute could be resolved only through negotiations and that it wasn't a matter that could be resolved by the courts. According to Matthews, Chandra Shekhar was close to clinching a solution. This involved the Muslims surrendering the disuted site to the Hindus while being compensated with land elsewhere in Ayodhya and a promise that no other temple issue would be re-opened. This is a remarkable disclosure considering that that is how the issue has finally been settled.

Chandra Shekhar laid no claim to be a saint or even being free from corruption. He was frank enough to accept that the the political machine is greased by tainted money and that if he wanted to be in politics, he had to live with the fact. In politics, such frankness is not appreciated. You need to be a hypocrite. Chandra Shekhar's image was badly dented by his open association with a coal Mafia don in Bihar and with godman Chandra Swami.

Matthews book provides plenty of background on the crucial political and economic issues in Chandra Shekhar's time. However, he has little to document by way of Chandra Shekhar's concrete achievements, given that his subject had little opportunity to demonstrate his remarkable talents. 

This biography is a useful reminder that India does not lack political talent. Those who rise to the top in Indian politics have the leadership and administrative qualities needed to steer the country. People fret about our corrupt and bungling politicians. Matthews book drives home the point that the nation is safe in their hands.

RBI action against HDFC Bank

 The RBI has come down heavily on HDFC Bank for disruptions in its online payment services. It has barred the bank from expanding its credit card  and digital business until the IT issues are satisfactorily addressed. 

RBI Governor Das took the unusual step of explaining the rationale for the central bank's move. He said, "You see, you cannot put thousands or lakhs of customers who are using digital banking into any kind of difficulty for hours together... It is important that the public confidence in digital banking is maintained".

It is indeed significant that the regulator has asked the board of HDFC Bank to fix accountability for the lapses on the IT front.  This is something one would expect of any board but we know this seldom happens.

The RBI's action against the leading private bank in the country is quite remarkable. In the past, there was a feeling that the regulator was treating the new private banks with kid gloves. Typically, monetary penalties of a few million rupees were levied, which were nothing but a rap on the knuckles. It was during the tenure of Governor Urjit Patel that fines were ramped up significantly and neither private nor foreign banks were spared. The RBI did not go along with the decision of the board of Axis Bank to extend the tenure of its then CEO. 

Under Das, the RBI has gone further. The CEO of Yes Bank was asked to stepped down and then the board was superseded. At HDFC Bank, the appointment of two executives to the board just months before the end of the tenure of CEO Aditya Puri was rejected. Bandhan Bank was penalised for not complying with the requirement to reduce promoter's shareholding below 40 per cent. And there was the tussle with Kotak Bank over reduction in the promoter's stake. 

It was the RBI's discussion paper on corporate governance in banks released a few months ago that stood out. The report is ownership-neutral in its approach to governance. It highlights the fact that the functioning of key officers- the Chief Risk Office, the Chief Compliance Office, the Head of Internal Audit and the Chief Vigilance Officer- is unsatisfactory and this is because of the manner in which they are appointed and appraised and whom they report. The paper proposes a radical overhaul in corporate governance at banks, irrespective of ownership.

This was refreshingly different from the approach of the P J Nayak committee (2014) which gave the impression that governance issues were predominant at public sector banks and that these banks needed to adopt the ownership structure and other practices at private banks.

Private banks do better not because of superior governance, meaning the functioning of boards and compliance with regulations, but for a variety of other reasons: a clear focus on making profit, the absence of government mandates to pursue particular objectives such as financial inclusion, superior incentives for top management and, well, sharp business practices that public sector banks cannot emulate. The RBI's actions show a welcome recognition of the shortcomings in governance at private banks. 

Killings fields of Afghanistan and an assassination

 The New York Times and The Washington Post carry on their front pages global news mostly on the basis of their importance and American news has to compete for attention with news from elsewhere. Indian papers, in contrast, are extremely India-centric in their coverage and most foreign news is relegated to one or two of the inside pages.

So you may not have heard of the scandal in Australia over the killing of Afghan civilians by Australian special forces stationed in the country. It was cold-blooded killing, with junior soldiers often being asked to shoot prisoners to get a taste of killing.

An enquiry has been  held into these war crimes and 25 soldiers found to have been involved in unlawful killings. However, the report of the enquiry has been quick to exonerate the superiors of these soldiers for their conduct. The finding has evoked widespread ridicule and criticism. Australian PM Scott Morrison has been constrained to reject this finding. This has embarassed the chief of Australian Defence Forces, who had echoed the findings of the report.

A complication for Australia is a tweet from a Chinese foreign ministry spokesman on the subject. The tweet carried the photo of an Australian soldier slitting a child's throat. Relations between Australia and China have been strained in recent months and the Chinese are making the most of this episode.

Here's a scorching commentary on this ugly episode in Russia Today. 

Then, there is the assassination of Iranian nuclear scientist Fakhrizadeh about a week ago. The scientist, who is said to have headed a covert nuclear weapons program, was killed just outside Tehran  in an encounter that could be straight out of Mission Impossible. The initial reports said he was killed by a commando squad that leapt out of a vehicle as his car, along with an escort of bodyguards, made his way to a town on the outskirts of Tehran.

Now, we are told he was killed by a remote-controlled machine gun that was operated through a satellite! Iranian fingers are pointed towards Israel. How any agency could have pulled off such a feat in the heart of Iran is a mystery. Clearly, there is logistical and other support provided by individuals or groups within Iran at a time when the country is reeling under sanctions. Whatever the methods used, the episode highlights Iran's vulnerability and the ability of its enemies to strike inside Iran at will. Hard questions are being asked of Iran's security establishment.

Iran has vowed revenge. It did likewise when Iranian commander Qassem Soleimani was killed in a US drone attack some months ago. At the time, Iran confined itself to a limited attack on US bases in Iraq. In the present instance, it faces a dilemma. If it retaliates, it will invite a massive response from the Israel and the US. That will put paid to Iran's hopes of a return to the nuclear agreement, signed during the term of President Obama, under the incoming Biden regime. (Trump has scrapped the agreement). If it lies low, it risks emboldening its enemies who will conclude that there are no costs to killing Iranian civilians in Iran.

RBI report on bank ownership raises a storm

The report of the Internal Working Group of RBI on bank ownership has unleashed a storm of mostly negative comment.

Leading the charge are Raghuram Rajan and Viral Acharya, as this report bears out.  Rating agency S&P has raised concerns as have many banking analysts. 

Most of the recommendations are unexceptionable. For instance, the recommendation that promoter's be allowed to retain their stake at 26% instead of the current ceiling of 15% after having diluted to 40% by the end of five years of starting a bank. Promoters have exercised full control even at the lower stake of 15%, so why not let them  exercise control with more skin in the game at 26%? Point taken.

Then, the idea that entities with multiple financial interests should come in through the Non Operating Holding Company Route. This is merely a reiteration of a position the RBI has held for long.

The hot potato is the recommendation on letting corporate houses into banking. This can take one of two forms. Corporate houses with no interest in banking-related activities can come in. Secondly, those who own NBFCs can convert these into banks. For the first category, the report suggests that the Banking Regulation Act be amended to give the RBI adequate powers to track and supervise inter-connected lending amongst corporates. For the second category, the report says that the current record of NBFCs, 'fit and proper' criteria for promters, etc be applied.

The difference in treatment is baffling. If corporate houses that are new to banking are to be effectively monitored, so are corporate houses that own NBFCs. Amendments to the Banking Regulation Act should be a condition precedent for either category.

And the concerns are identical to both categories- one is not riskier than the other (although it could be argued that NBFC-owning entities that do not have a significant exposure to non-finance or industrial activities are less of a problem).

Inter-connected lending is not easy to track and supervise. It's very difficult for the supervisor to judge whether an entity is part of a group or not. And how does the supervisor keep watch on funding of a corporate's suppliers and customers? 

The problems of inter-connected lending are well known. Not as well recognised are the issues that can arise on the liabilities side. Corporates park their cash surpluses with banks at negotiated rates. A corporate owning a bank may be able to get a price on its surpluses that is above the market rate at a given point in time- in effect, the concerned company will be gaining at the expense of the bank. 

Banks have privileged access to information. They have better information that the public on the current financial condition of their clients, the status of projects, which companies in a group are doing well and which aren't, projects that clients are bidding for, etc. A corporate owning a bank will have access to the information and hence an informational advantage over rivals.

One could go on and on. The conflicts of interest inherent in letting a corporate house into banking are mind-blowing. Managing these conflicts is beyond the competence of even the most upright and competent regulator. The regulator will fail in this unequal contest and its reputation will take a beating. The entry of corporate houses into banking, make no mistake, is a threat to financial stability.

More in my article in the Hindu, Say 'no' to corporate houses in Indian banking.

As the article is behind a pay wall, here it is:

Say ‘no’ to corporate houses in Indian banking

The banking sector needs reform but the recommendation of corporate-owned banks is neither ‘big bang’ nor risk free

T.T. Ram Mohan

An Internal Working Group of the Reserve Bank of India (RBI) has recommended that corporate houses be given bank licences (https://bit.ly/3fqoLlo). In today’s pro-business climate, you would have thought the proposal would evoke jubilation. It should have been hailed as another ‘big bang’ reform that would help undo the dominance of the public sector in banking. Instead, the reaction has ranged from cautious welcome to scathing criticism. Many analysts doubt the proposal will fly. It is worth examining why.

First, the idea

The idea of allowing corporate houses into banking is by no means novel. In February 2013, the RBI had issued guidelines that permitted corporate and industrial houses to apply for a banking licence. Some houses applied, although a few withdrew their applications subsequently. No corporate was ultimately given a bank licence. Only two entities qualified for a licence, IDFC and Bandhan Financial Services.

The RBI maintained that it was open to letting in corporates. However, none of the applicants had met ‘fit and proper’ criteria. The IWG report quotes the official RBI position on the subject at the time. “At a time when there is public concern about governance, and when it comes to licences for entities that are intimately trusted by the Indian public, this (not giving a license to any corporate house) may well be the most appropriate stance.”

In 2014, the RBI restored the long-standing prohibition on the entry of corporate houses into banking. The RBI Governor then was Raghuram G. Rajan. Mr. Rajan had headed the Committee on Financial Sector Reforms (2008). The Committee had set its face against the entry of corporate houses into banking. It had observed, “The Committee also believes it is premature to allow industrial houses to own banks. This prohibition on the ‘banking and commerce’ combine still exists in the United States today, and is certainly necessary in India till private governance and regulatory capacity improve. (https://bit.ly/3ftp7Yf)” The RBI’s position on the subject has remained unchanged since 2014.

The worry is the risks

What would be the rationale for any reversal in the position now? The Internal Working Group report weighs the pros and cons of letting in corporate houses. Corporate houses will bring capital and expertise to banking. Moreover, not many jurisdictions worldwide bar corporate houses from banking.

It is the downside risks that are worrying in the extreme. As the report notes, the main concerns are interconnected lending, concentration of economic power and exposure of the safety net provided to banks (through guarantee of deposits) to commercial sectors of the economy. It is worth elaborating on these risks.

Corporate houses can easily turn banks into a source of funds for their own businesses. In addition, they can ensure that funds are directed to their cronies. They can use banks to provide finance to customers and suppliers of their businesses. Adding a bank to a corporate house thus means an increase in concentration of economic power. Just as politicians have used banks to further their political interests, so also will corporate houses be tempted to use banks set up by them to enhance their clout.

Not least, banks owned by corporate houses will be exposed to the risks of the non-bank entities of the group. If the non-bank entities get into trouble, sentiment about the bank owned by the corporate house is bound to be impacted. Depositors may have to be rescued through the use of the public safety net.

The Internal Working Group believes that before corporate houses are allowed to enter banking, the RBI must be equipped with a legal framework to deal with interconnected lending and a mechanism to effectively supervise conglomerates that venture into banking. It is naive to suppose that any legal framework and supervisory mechanism will be adequate to deal with the risks of interconnected lending in the Indian context.

Corporate houses are adept at routing funds through a maze of entities in India and abroad. Tracing interconnected lending will be a challenge. Monitoring of transactions of corporate houses will require the cooperation of various law enforcement agencies. Corporate houses can use their political clout to thwart such cooperation.

Second, the RBI can only react to interconnected lending ex-post, that is, after substantial exposure to the entities of the corporate house has happened. It is unlikely to be able to prevent such exposure.

Third, suppose the RBI does latch on to interconnected lending. How is the RBI to react? Any action that the RBI may take in response could cause a flight of deposits from the bank concerned and precipitate its failure. The challenges posed by interconnected lending are truly formidable.

Regulator credibility at stake

Fourth, pitting the regulator against powerful corporate houses could end up damaging the regulator. The regulator would be under enormous pressure to compromise on regulation. Its credibility would be dented in the process. This would indeed be a tragedy given the stature the RBI enjoys today.

What we have discussed so far is the entry of corporate houses that do not have interests in the financial sector. There are corporate houses that are already present in banking-related activities through ownership of Non-Banking Financial Companies (NBFCs).

Under the present policy, NBFCs with a successful track record of 10 years are allowed to convert themselves into banks. The Internal Working Group believes that NBFCs owned by corporate houses should be eligible for such conversion. This promises to be an easier route for the entry of corporate houses into banking.

The Internal Working Group argues that corporate-owned NBFCs have been regulated for a while. The RBI understands them well. Hence, some of the concerns regarding the entry of these corporates into banking may get mitigated. This is being disingenuous.

There is a world of difference between a corporate house owning an NBFC and one owning a bank. Bank ownership provides access to a public safety net whereas NBFC ownership does not. The reach and clout that bank ownership provides are vastly superior to that of an NBFC. The objections that apply to a corporate house with no presence in bank-like activities are equally applicable to corporate houses that own NBFCs.

Points to privatisation

There is another aspect to the proposal that cannot be ignored. Corporate houses are unlikely to be enthused merely by the idea of growing a bank on their own. The real attraction will be the possibility of acquiring public sector banks, whose valuations have been battered in recent years. Public sector banks need capital that the government is unable to provide. The entry of corporate houses, if it happens at all, is thus likely to be a prelude to privatisation. Given what we know of governance in the Indian corporate world, any sale of public sector banks to corporate houses would raise serious concerns about financial stability.

India’s banking sector needs reform but corporate houses owning banks hardly qualifies as one. If the record of over-leveraging in the corporate world in recent years is anything to go by, the entry of corporate houses into banking is the road to perdition.

 

 

 

Rescue of Lakshmi Vilas Bank

 RBI's move to get  Lakshmi Vilas Bank to merge with DBS India removes a huge uncertainty for depositors. They can now breathe more easily. 

Saving small depositors is an important consideration for the regulator in India. The political costs of letting them go to the wall are unaffordable. But a bank rescue also makes good economic sense. A branch with over 560 branches has franchise value. What's the point in liquidating it? You are not going to raise enough to pay depositors and you will be starving borrowers of funds. The issue is a requirement of capital. LVB management tried hard to raise capital but failed- they obviously didn't inspire confidence in investors. The next best thing was to look for buyer with deep pockets. DBS fills the bill.

The good thing is that LVB has not been foisted on a public sector bank. The scapegoat would have been SBI in the normal course but it was obviously not available after having to reckon with Yes Bank. PNB, the other potential scapegoat, is wrestling with its ongoing merger with OBC.

Is the acquisition of LVB by DBS a pointer to the shape of things to come? Do we expect more foreign banks to come in and acquire assets in the Indian banking sector? I doubt very much. If foreign banks are to acquire Indian entities, they will need to have wholly owned subsidiaries (WOS) in India. Only two foreign banks have shown an appetite for such subsidiaries. (DBS is one of them). 

A WOS  is subject to stringent governance requirements, including the requirements that 50 per cent of the directors should be Indian and one-third must be independent directors. Foreign banks may not be comfortable with such requirements. Nor do they have much of an appetite for infusing capital into emerging markets in a big way, given that are grappling with higher capital requirements in their home markets consequent to Basel 3 norms. 

Besides, foreign banks would think hard about organic growth in a market in which both PSBs and private banks have substantial distribution networks. They would be more interested in growing through acquisition of PSBs. That is a no-no at the moment. The government needs to amend the Bank Nationalisation Act to facilitate such acquisitions. Besides, the RBI is wary of the financial stability implications of a large foreign bank presence. The foreign bank policy unveiled in 2013 says:

From financial stability perspective down side risk may arise if the foreign banks, i.e. WOSs of the foreign banks and foreign bank branches together come to dominate the domestic financial system. To address this risk, restrictions would be placed on further entry of new WOSs of foreign banks, when the capital and reserves of the foreign banks (i.e. WOSs and foreign bank branches) in India exceed 20% of the capital and reserves of the banking system. 

The RBI is unlikely to change its stance even though there is a large need for capital. It would be more receptive to acquisitions of PSBs by Indian entities, whether corporate houses or large NBFCs that convert themselves into banks. The timing of the recommendations of the RBI's internal working group on the subject are thus significant.

LVB shareholders are upset that equity is being written of in the proposed merger. At Yes Bank, bond holders had to take some of the hit, so why not in this case? Well, the RBI does not have a consistent policy on this issue, as this piece in BQ shows. One must reckon that the write off at LVB was intended to make the proposal palatable to DBS. 

More in my BQ article, The Lakshmi Vilas Bank Rescue does not mark a trend.

 

 

 

Pandemic's economic impact was exaggerated

 When the pandemic erupted in a big way in the US and Europe and engulfed the rest of  the world, including India, many forecasts verged on the apolycaptic. We were told that the global financial crisis would pale in comparison with the havoc wrought by the pandemic.

This is not unusual. Overshooting of forecasts is as common as overshooting of stock prices or exchange rates. In 1987, when the stock market crashed (for technical reasons), many in the US gloomily forecast the end of capitalism. They were proved wrong- the markets and the economy bounced back quickly.Then came the millenium IT bug and the imminent collapse of software systems. The millenium came and went without any turbulence. The global financial crisis was, in some sense, the real thing. But its impact was felt more in the advanced economies and, amongst these, the US recovered faster than Europe.

On now to the pandemic. The immediate impact of the pandemic is turning out to be greater than that of the financial crisis- in other words, the trough is deeper. But the bounce back promises to be faster. One reason is that banking systems have proved resilient, unlike in the global financial crisis, thanks to bigger capital buffers at banks. Another is a greater willingness on the part of policy makers to do what it takes in respect of fiscal stimulus. A third is that the fatality rate in the pandemic is lower than initially feared and this has emboldened governments everywhere to ease lockdown restrictions faster than supposed.

There is, of course, the second wave in Europe and US and the fear of a similar wave elsewhere. But the trend towards easing of restrictions on economic activity is unlikely to be reversed a great deal. So, the loss of economic output will be not as great as in the financial crisis.

More in my BS column, Covid shock versus global financial crisis

Robert Fisk, peerless journalist

Robert Fisk, one of UK's globe-trotting journalists in the tradition of James Cameron and John Pilger (Pilger worked for British papers although he's an Australian), passed away recently.

Fisk was a fearless reporter who distinguished himself with his coverage of the Middle East, mostly from Beirut which had become a second home to him. Western coverage of the Middle East is hopelessly biased in favour of Israel and is often no more than an arm of Western propaganda. It routinely portrays the struggles of the people there as acts of terrorism. 

Fisk was different. He was unbiased in his reporting and he showed a lot of empathy for the suffering he saw and chronicled. Not many Western papers other than the Independent would have been willing to host him. There aren't many like Fisk in journalism today. Robert Parry, the American investigative reporter, is no more. Seymour Hersh, another American great, is still around. In an era of fake news, Fisk will be greatly missed.

Here's an obit in the Independent. Patrick Cockburn, another veteran journalist, pays a tribute here.

Air India disinvestment

Air India's disinvestment- or, more accurately, privatisation- is stlll on after having been started in January, 2020. (An earlier attempt in 2018 proved unusccessful). 

After contemplating a majority stake sale initially, the government decided to sell 100 per cent of equity in Air India at one go. According to media reports,  it has also moved about half of the debt out of Air India to a Special Purpose Vehicle. The debt that remains is around Rs 23,000 crore and this is said to relate to the aircraft bought by AI.

Neither of these has sufficed to attract bidders thus far. The government, it is reported, is now offering a further sweetener. It has allowed bidders to choose how much of the existing they would like to take up in making their offers for equity.

I must confess I am not able to fathom what this means. 

Let us take V =D +E, where V is the value of the firm, D is the debt and E the value of equity.

Bidders will estimate a value for V. In bidding for equity, they will subtract D from V. If they want to take up less debt, they will bid more for equity; if they want more debt, they will bid less. I guess that is the proposition being made.

But this holds true only if V remains unchanged with the change in debt. I can't see how this is possible. Most of the debt in AI relates to aircraft. If some of the debt is to moved out, some of the aircraft too will have to go. When that happens, V drops correspondingly, leaving E unchanged. 

Can somebody explain to me how leaving it to bidders to choose the level of debt is going to help?

There is another thought. If moving out debt is going to make AI more attractive, that is, it will improve the bottomline, why can't the government keep AI? After all, the presumption underlying disinvestment is that AI will continue to bleed, that is why it's important for the government to get AI off its hands.

One final point. It is important that the government realise the correct value for AI assets, however the deal is structured. If the sale is under-priced, there is little incentive for the bidder to improve efficiency- the bidder gains without having to lift his little finger. Secondly, if AI is not correctly priced, the deal could invite a legal challenge, which would mean that it will be stymied for quite some, leading to a further worsening of performance.

Do lockdowns make sense?

Do lockdowns work? Was India right in imposing what was, perhaps, the most stringent lockdown in the world? I had a post earlier on this subject in which I cited the IMF's findings to say that these appear to bear out the correctness of our approach.

Subsequently, a government panel staffed by top scientists also lent support to the approach taken by the government. The committee observed:

Without a lockdown, the number of deaths in India would have overwhelmed the system within a very short timeframe, and would have eventually crossed 26 lakh fatalities. Imposing the lockdown in May would have reduced deaths to around 10 lakh. The prompt imposition of the lockdown on March 24 has resulted in deaths being around one lakh till date.  

The committee was also of the view that cases had peaked in September and we should see a decline hereafter, provided people continued to be careful.

Some nagging questions, however, remain. Why was India's record, despite a stringent lockdown, poorer than that of, say, Bangladesh and Pakistan? The lockdown may have slowed the spread- and hence made it possible for the health infrastructure to cope- but why did not result in fewer numbers?   And if the numbers that resulted were as high as they have been, was the loss of livelihoods worth the cost? It would be useful if the committee were to provide answers.

One thing is for sure: the last word on the merit of lockdowns has not been said. Surjit Bhalla has done some research on the subject and he contends in an article today that lockdowns have not been effective in this pandemic nor considered effective in earlier pandemics in the US! In other words, it's not just India where the lockdown did not produce results; this was true of other parts of the world as well. His conclusions are worth reproducing:

In my paper, I report the result of various studies on the effectiveness of lockdowns; except for a few, most of these studies report that the lockdowns were highly successful in saving hundreds of thousands of lives. Since the average death rate from COVID is 2.5 per cent, these results imply that somewhere between 10 to 20 million less infections resulted from this unnatural experiment.

Examination of the contradiction between the observed reality of 40 million cases, and the experimental reality of lockdown research, is the purpose of my above-mentioned paper. We replicate the variety of tests available in the literature and add the following important test of lockdowns — a before-and-after comparison for over 150 countries, and for one, two, and three months from the date of lockdowns. No matter what the test, the dominant result is that not only lockdowns were not effective, but that, in a large majority of cases, lockdowns were counter-productive i.e. led to more infections, and deaths, than would have been the case with no lockdowns. My analysis stops in end-July and, therefore, ignores the post-July second wave of infections. If these data are included, the fate of lockdowns would be a lot worse.

 Bhalla goes on step further and questions the efficacy of non-phamaceutical interventions, such as wearing masks and washing one's hands. He cites a WHO report on the subject:

The evidence base on the effectiveness of NPIs in community settings is limited, and the overall quality of evidence was very low for most interventions. There have been a number of high-quality randomised controlled trials (RCTs) demonstrating that personal protective measures such as hand hygiene and face masks have, at best, a small effect on influenza transmission, although higher compliance in a severe pandemic might improve effectiveness. 

In short, Bhalla thinks it doesn't make any difference to the spread of the infection whether you have a lockdown or not and whether people protect themselves with what we have come to regard as basic safeguards, such as masks and washing of hands! Here's another post I came across that accords with Bhalla's view on lockdowns.

There is one person who would heartily approve of Bhalla, President Trump. Unlike much of the intelligentsia, I have great respect for the instincts of politicians and I am left wondering whether Trump has latched on to something that was lost on many experts.

'Consensus' is not a good guide to decision-making.

I never forget that I am lodged in  a B-school, so I like to put on my management hat every now and then. (Which is why I wrote a book on the corporate world in 2015, Rethinc: What's broke at today's corporations and how to fix it).

In that spirit, I find myself agreeing with the departing head of Swiss bank UBS, Sergio Ermotti. Ermotti has revived UBS after the setback it faced in rogue trader scandal in 2011. In an interview, he details how he brought about the turnaround. One of the things he mentions is how there was a terrific clamour among analysts, shareholders and journalists that he shut down the investment banking arm and the US wealth management arm. His instinct told him otherwise and he was proved right:

My best decision was not to follow consensus . . . I’m sure I wouldn’t be the CEO today if I had done it,” he says. “With hindsight it’s always easy [to second-guess], but as a leader, your first instinct is usually the right one . . . So if I have to learn anything, it’s to rely on those instincts even more.

This reminds me of  an anecdote that Peter Drucker narrates about Alfred Sloan, the legendary Chairman of General Motors. At one meeting, Sloan asked his colleages whether they should go ahead with a particular decision. Everybody around the table nodded assent. Sloan rose to his feet,"Gentlemen, if there is this kind of agreement with the decision, there must be something wrong with it. I suggest we adjourn and meet again". 

In other words, consensus can be lethal to decision-making. It shows there hasn't been application of mind or expression of opinion. There has to be a modicum of dissent, a weighing of pros and cons for a decision to be sound. Wherever you find a high degree of consensus, be a little wary of it.

Don't blame Modigliani-Miller for overleveraging in the corporate world

 An article  in the FT suggests that the Modigliani-Miller Theorem is responsible for over-leveraged companies and the wrecks they have left behind:

Franco Modigliani and Merton Miller both later won the Nobel Prize in economics, partly thanks to their groundbreaking work on what became known as the “M & M theorem”. Until then most companies had assumed that too much debt would affect the value of the firm, so their paper was a counterintuitive bombshell. Their initial findings only held in a world without “frictions” — such as taxes, imperfect information and inefficient markets. But a later revisitation that incorporated the tax-deductibility enjoyed by interest payments showed that the value of an indebted company is actually higher than that of an unleveraged one. It eventually helped lay the intellectual groundwork for a dramatic erosion of corporate creditworthines

I'm afraid the article gets it quite wrong. When they wrote that capital structure is irrelevant to the value of the firm, MM meant there is no particular gain in introducing debt into the capital strucure. Debt increased the return to equity; at the same time the expected return to equity also went up, that is, shareholders expected higher returns of a company exposed to the risk of debt. So, the higher return produced by debt was, in some sense, deceptive. 

The introduction of tax does enhance firm value through the tax shield provided by debt. But this is beneficial only up to a modest level. Beyond that level, the probability of bankruptcy erodes firm value. In other words, firms face a trade-off between the tax shield that debt provides and the increased probability of bankruptcy that it creates. 

In the real world, the most highly valued firms- Apple, Google, Micrososft, Infosys, TCS- are all debt free. They don't think it necessary to enhance shareholder value by injecting debt. There is so much value created through the intelligent deployment and utilisation of assets that tinkering with the liability side is rather redundant. The best managers would adhere to M-M and not resort to debt, certainly not to excessive debt.

In the world of banking, the downside to debt has come to be internalised after the global financial crisis, so banks have raced to give themselves capital far higher than what the regulators have mandated. HDFC Bank has a capital adequacy ratio of 17-18 per cent when the regulatory requirement is under 12 per cent. That is because the markets have come to reward well capitalised banks. It may well be that the valuation of non-financial firms in the markets does not yet reflect the risks entailed by debt. But you can't blame M-M for that.

Of M-M, it could well be said that they came to bury debt, not to praise it.

More on the IMF's recanting austerity

In a recent post, I wrote about the IMF discarding its austerity mantra in its latest World Economic Outlook Report. The FT has a detailed article on the about-turn. The author writes:

Carmen Reinhart, the eminent economic historian who is now chief economist at the World Bank, recommended countries should borrow heavily during the pandemic. “While the disease is raging, what else are you going to do?” she asks. “First you worry about fighting the war, then you figure out how to pay for it.” Ms Reinhart was a leading advocate of austerity a decade ago after publishing a research paper which concluded that at a similar stage in the 2008-09 financial crisis — to where we are now — high levels of public debt undermined economic performance. It concluded that, “traditional debt management issues should be at the forefront of public policy concerns”.

The author mentions three reasons for the change in the IMF stance. One, the experience post the global financial crisis when fiscal policies  remained relatively restrained while monetary policy was assigned the task of restoring normalcy. It didn't quite work. Now, central bankers urge that monetary policy must work in tandem with fiscal stimulus.

Two, interest rates have fallen steeply over the years and this makes a higher level of borrowing feasible. One wonders whether the fiscal deficit target of 3 per cent  of GDP under the Maastricht Treaty and the notion that debt to GDP in the advanced economies should be under 90 per cent hold water any more. We need to consider alternative indicators: say, the interest to GDP ratio or the ratio of interest to total government income. Better still we have to take a view on (r-g), the differential between the interest rate and  the GDP growth rate. If the interest rate has fallen more than the GDP rate of, say, two decades ago, then the old rules for fiscal policy no longer apply. There is, of course, the interesting question of why interest rates have fallen in the advanced world despite rising public debt and a huge expansion in liquidity- on that, more in a future post.

Three, there is little public appetite for austerity now after the havoc visited on jobs post the global financial crisis. The article notes that even conservative Germany takes pride in the fiscal stimulus it provided post the pandemic.

Carmen Reinhart's prescription, however, may not enthuse Kenneth Rogoff, Reinhart's co-author of the famous book on debt crises, This time is different. In an article in the Guardian written last December, Rogoff gives three reasons, not all of them persuasive. why one must be wary of assuming higher debt given low interest rates.

First, governments may be able to service higher market debt but they may be jeopardising their obligations under social security systems. Well, I guess the measurement issue can be addressed by including contingent liabilities, such as pensions, in government's debt obligations. Let’s monitor the total, public debt plus pension liabilities.

Secondly, the next crisis may be very different in character, say, global climate change or a cyber war, with unpredictable implications for growth and interest rates. This strikes one as something of a bogey. One is not saying the interest burden on government should rise. Let the interest burden in normal times remain the same as before after adjusting for lower interest rates. That means we are at the same level of risk as before in confronting unpredictable crises of the sort Rogoff talks about. Again, the debt level is the wrong indicator to target.

Thirdly, Rogoff argues that "aggressive experimentation with much higher debt might cause a corresponding shift in market sentiment – an example of the Nobel laureate economist Robert Lucas’s critique that big shifts in policy can backfire owing to big shifts in expectations." Well, such a shift has not happened  for well over a decade post the crisis. Markets are not factoring in higher inflation and interest rates consequent to the shift in policy. If it does, policy makers have room to adjust. 

IMF report vindicates India's approach to tackling pandemic

Was the government right in enforcing a stringent lockdown in response to the pandemic? Or was there overkill on its part ?

The questions have been hotly debated over the past several months. A common criticism is that, in trying to kill the pandemic, the  government ended  up killing the economy. We flattened the wrong curve, as Rajiv Bajaj said. meaning we flattened the GDP curve, not the pandemic curve. Prioritising lives over livelihoods was the wrong thing to do.

Well, this is not a debate that will end soon. But it's interesting to see the observations and conclusions contained in Chapter 2 of the IMF's latest World Economic Outlook. Let me highlight the important ones:

i. The more stringent the lockdown, the greater the impact on the economy

By looking at the effect on  GDP of the stringency of lockdown in a sample of economies (which does not include India), the report concludes:

...more stringent lockdowns are associated with lower consumption, investment, industrial production, retail sales, purchasing managers’ indices for the manufacturing and service sectors, and higher unemployment rates.4 These correlations persist with and without controlling for the strength of each country’s epidemic based on the total number of confirmed COVID-19 cases scaled by population. 

 ii. Easing the lockdown may not necessarily lead to a sharp revival in economic activity.

As long as the fear of getting infection persists, people will observe voluntary lockdown even if the government lifts its own.

However, lockdowns are not the only contributing factor to the decline in mobility. During a pandemic, people also voluntarily reduce exposure to one another as infections increase and they fear becoming sick.....Both lockdowns and voluntary social distancing had a large impact on mobility, playing a roughly sim-ilar role in emerging markets. The contribution of voluntary social distancing was smaller in low-income countries and larger in advanced economies.

Just think of the large number of proprietary establishments. Are the owners going to be in a hurry to re-open when cases are rising? Most unlikely. It's not clear, therefore, that an early lifting of the lockdown would have let to a spurt in economic activity in India.

iii. The more stringent the lockdown, the greater the chance of reducing the rate of spread of the infection.

Lockdowns engender sizable short-term economic costs, but they are also an investment in public health to protect susceptible populations from the highly transmissible virus.... Countries that imposed lockdowns faster experienced better epidemiological outcomes. The differences are even more striking if countries are divided with respect to the number of COVID-19 cases at the time of lockdowns.... Countries that adopted lockdowns when COVID-19 cases were still low witnessed considerably fewer infec-tions during the first three months of the epidemic compared with countries that introduced lockdowns when cases were already high.

Based on the above, the IMF comes to the following conclusion:

The observation that lockdowns can reduce infections but involve short-term economic costs is often used to argue that lockdowns involve a trade-off between saving lives and protecting livelihoods. This narrative should be reconsidered in light of the earlier findings showing that rising infections can also have severe detrimental effects on economic activity. By bringing infections under control, lockdowns may thus pave the way to a faster economic recovery as people feel more comfortable about resuming normal activities.

It's hard to argue that what India did was anything different from what has been outlined above. You could argue that despite having a stringent lockdown, we did not experience a quick reduction in the incidence of cases. It may be that the norms for social distancing, wearning of masks etc were not taken seriously, so we did not experience the expected benefits. But it's also true that we have no means of knowing the counter-factual: what the incidence of cases might have been sans a lockdown.

My guess is that the mass movement of migrant labour may have resulted in sub-optimal outcomes in India. Maybe we failed in providing the support that would have kept migrants where they were. Maybe the fear psychosis over the spread of the virus and the contention that migrants were hugely at risk resulted in a panic reaction.

We were also in the difficult position of not having the healthcare infrastructure in place, so we could not afford an explosion in cases at the very start. Six million cases over six months can be handled; not so, six million cases in the first couple of months.

While on the subject, the recurrence of cases in Europe points to the hazards of relaxing restrictions too soon, even in places where social awareness and discipline is said to be higher than in our country. Germany, France, the UK,  the Netherlands and others are re-imposing restrictions in varying degrees.

Health systems around the continent are switching to crisis mode as hospital wards begin to fill up with Covid-19 patients. Fears are growing that medical facilities could soon be inundated and that the swelling volume of new cases could overwhelm track-and-trace teams tasked with interrupting the virus’ chains of transmission.

....Virus cases started to tick upwards after European governments eased lockdowns over the summer to kickstart economies that had been hit hard by the restrictions. But public health experts say Europeans let down their guard, holidaying abroad in large numbers, ignoring social-distancing rules and gathering in groups to eat, drink and socialise.

In the week to October 11, Europe registered its highest weekly number of Covid-19 infections since the pandemic began, with almost 700,000 new cases, according to WHO statistics.

No, we don't need austerity, says IMF!

 The IMF does not prescribe austerity any more- at least not for the advanced economies.

The advanced economies have resorted to a large fiscal stimulus in response to the pandemic. The IMF World Economic Outlook, October 2020, estimates that discretionary stimulus amounts to 9 per cent of GDP in advanced economies (compared to 3.5 per cent of GDP in emerging economies). 

Public debt in advanced economies is poised to rise by a full 20 percentage points to 125 per cent of GDP by the end of 2021 (in emerging economies, the figure will be 65 per cent of GDP). Yet, the IMF thinks the rise in debt will not be a big deal for the advanced economies.

Why? Because interest rates have fallen to close to zero in the advanced world, so more debt does not translate into an unsustainable interest burden. There's more debt but it's cheaper now. As a result, by 2025, overall deficits will be back to pre-pandemic levels without any cuts in public spending, according to a report in the FT:

Most advanced economies that can borrow freely will not need to plan for austerity to restore the health of their public finances after the coronavirus pandemic, the IMF has said in a reversal of its advice a decade ago. Countries that have the choice to keep borrowing are likely to be able to stabilise their public debt by the middle of the decade, Vitor Gaspar, head of fiscal policy at the fund, told the Financial Times. That would mean they would not have to raise taxes or cut public spending plans.

As the report notes, this is a change in the IMF's position with respect to what it had advocated after the global financial crisis.

The IMF is now urging advanced economies to spend their way out of trouble. Growth will take care of debt sustainability because the growth factor 'g' will outweigh the interest rate factor 'r'. 

But the point is that this - the positive gap between growth and interest rate- is not happening by accident. It is happening because central banks are intervening in the debt markets to make it happen. Central banks first allowed the policy rate to drop to close to zero at the lower end of the yield curve. Then, they resorted to Quantitative Easing which is the purchase of a defined amount of government bonds from investors. They have followed this up with Yield Curve Control, which is defining the interest rate they want to see at the higher end of the yield curve.

If central banks elsewhere can make it easier for governments to borrow, why is it a problem if the RBI does the same here? Why is the management of interest rates to facilitate more government borrowing and spending such an issue here? Why the criticism that fiscal dominance dictates monetary policy?

There is merit in what the proponents of Modern Monetary Theory are saying. They say that it's not true that government borrowing drives up interest rates because there is a limited pool of savings to finance it. When the government spends, the interest rate falls, it does not rise. There is an accretion to bank reserves at the central bank. This causes the inter-bank rate, which is the anchor rate in advanced economies, to fall, thereby facilitating more government borrowing and spending.

There is only one constraint in central banks allowing interest rates to fall: the fall in interest rates must not spell higher inflation. This is a constraint in India at the moment, given that inflation has been at over 6 per cent in recent months, that is, beyond the upper bound of the the inflation target framework. However, once the inflation rate falls, there is nothing that stands in the way of a cut in the policy rate. And until then, managing yields at the higher end of the curve is par for the course.

Central bank independence: Response to a reader's comment

In response to my post on central bank independence, a reader comments:

Aren't you using the pandemic-induced exceptional circumstance to rubbish Acharya's thesis? Granted that exceptional situations require a less doctrinaire approach but that apart i think there is merit in the view that a restructured standard asset is an oxymoron. I am one with you on accountability though. Take the issue of bank supervision. Musn't the RBI be held accountable for sleeping at the wheel and waking up too late to the crisis, the more so given its nominees were on the Boards of PSU banks? There cannot be independence without accountability.  

First, my basic problem is with Viral Acharya's thesis that fiscal dominance is the root cause of our banking woes. If that were so, how does one explain recurrent banking crises in economies where there has been no fiscal dominance? 

Adair Turner, former Chairman of UK's Financial Services Authority, explains in his book, Between Debt and the Devil, that money creation happens either by government or through the banking system. He argues that both can be equally irresponsible in the creation of money. The financial crisis was the result, not of fiat money created by government, but excess loan creation by private bankers. So, the idea that if government practises fiscal prudence, banking crises will somehow disappear seems rather misplaced.

Secondly, about loan restructuring or 'kicking the can down the road'. At the risk of sounding heretical, I make bold to say that without some kicking of the can down the road, it's impossible to practise banking. The question is one of proportion. If, say, 5 per cent of loans are restructured, it is not an issue; if the proportion of 25 per cent, there is certainly an issue. Next, restructuring must be based on sound financial considerations, it should not happen for mala fide reasons. Subject to these to two caveats, one should not have an issue with loan restructuring. 

Especially in the case of infrastructure projects and SMEs, where cash flows can be uncertain for reasons beyond the control of firm management, one cannot rigidly apply NPA norms and despatch the firm to IBC. Bankers need to exercise their judgement in handling such cases. That they refuse to in today's fraught environment is a different matter.

Thirdly, about the accountability of RBI. Not all of the bad loan problem is the result of irresponsible lending. The Economic Survey of 2016 argued persuasively that much of the NPA problem was the result of factors extraneous to management: 

Without doubt, there are cases where debt repayment problems have been caused by diversion of funds. But the vast bulk of the problem has been caused by unexpected changes in the economic environment: timetables, exchange rates, and growth rate assumptions going wrong.

   

So the idea that there was a colossal management failure at PSBs to which the RBI nominees were party is suspect, to say the least.

 

Where the RBI, perhaps, went wrong was in its over-zealous approach to NPA recognition under the Asset Quality Review. In one year, 2016, the ratio of gross NPAs to advances jumped to 7.48 per cent from 4.27 per cent in 2015. This led to a severe capital crunch, which affected credit growth, which affected borrowers and led on to more NPAs.

 

One could argue that it was not lack of central bank independence but the assertion of independence through an extremely stringent AQR that led on to major problems for the banking sector and the economy at large. The issue was not so much lack of supervision as the RBI's response to the NPA issue when it surfaced. This also was the reason for the tensions that emerged between the RBI and the government. 

Next round of fiscal stimulus: Question is when and how to do it

The Indian government has received much stick for the weak stimulus it has given so far, amounting to about 2 per cent of gdp. 

Following the onset of the pandemic, other economies vied with each in doling out large stimuli, covering support for both individuals and firms across the board. The government here chose to be far more cautious  and relied instead on monetary policy and the banking channel to ride out the lockdown.

Six months on, it does appear that the government called correctly. The economic outcomes from large fiscal stimulii elsewhere have been pretty modest. Even after sticking to borrowing limit of Rs 12 crore, which is the limit set for now, India's combined fiscal deficit for the centre and the states will be around 12 per cent of gdp. Any further stimulus will cause the fiscal deficit and  public debt to rise to a level where  a rating downgrade becomes inevitable, followed by an exodus of foreign capital.

More importantly, we have seen that large fiscal stimulii have not been effecting during the lockdown. Massive cash transfers and payroll support for businesses has not prevented a contraction in GDP. The stimulii have been wasted, so to speak, and the advanced economies have seen their debt to gdp ratios rise to well above 100 per cent.

Now that the lockdown is well under way, is it time for another dose of fiscal stimulus? Yes, except that inflation is now trending at above the inflation target limit of 6 per cent. We may opt for another round of fiscal stimulus once inflation falls below 6 per cent- and, I would argued, it should happen through direct monetisation of the deficit. Then, fiscal deficit does not rise. Inflation would have fallen below 6 per cent. More government spending can happen without inviting a rating downgrade.

More in my BS column, Now is not the time for stimulus

Is Trump authoritarian?

US President Donald Trump is portrayed as part of the current set of authoritarian leaders that includes Russia's Putin, Turkey's Erdogan and Brazil's Bolsanaro.

An article in the FT makes the interesting point is that Trump's instincts are libertarian rather than authoritarian. He simply doesn't match the profile of the classic authoritarian leader  who favours greater use of executive power. The author argues that Trump wants to roll back the state, not advance its frontiers:

If the president’s illness has shown anything, it is that he differs from classic strongmen in a very US way. His populism tends more to the libertarian than the repressive. The mask-spurning, the cavalier gatherings, the call to not let the virus “dominate”: it is personal freedom to which the president has shown a heedless attachment. A conventional despot would use the pandemic as a pretext to hoard and exploit executive power. Mr Trump has used it to define himself against a meddling state. His line of attack against Joe Biden, the Democrat candidate, is that he would smother America’s economic bounceback with fussy curbs on everyday life. 

In other ways too, Trump's instincts go counter to those of the classic autocrat. He is wary of the military, he doesn't favour too much of a fiscal stimulus and he doesn't want the state intruding into the life of the ordinary person. 

Trump may brush aside rules, his utterances may be jingoistic, he may be impatient with criticism but  he is not your classic dictator who uses the state to repress citizens. Liberals are wont to call somebody they think is unpleasant 'authoritarian' but that doesn't make the characterisation accurate.

 

Inflation targeting in India: RBI's mandate must be modified

Barry Eichengreen, the well known economist, thinks inflation targeting is working in India and that it's good to stick to it. His views come at a time when the regime is seen to be coming in the way of cranking up growth just when the economy is suffering a huge contraction.

Eichengreen cites a co-authored paper of his which shows that the inflation targeting regime is "functioning well" in India. The RBI uses both price stability and growth to determine its policy rate. Policy has not become more hawkish after the regime was put in place. It has made for better anchoring of inflation expectations. Even when the inflation rate moves up, inflation expectations don't go up because people believe the RBI is capable of reining it in. In other words, the credibility of RBI has gone up consequent to inflation targeting.

Eichengreen, however, sees room for improvement especially in RBI's management of expectations of inflation. The data shows that while the RBI is able to manage expectations of professionals well, it hasn't done a great job of managing the expectations of ordinary people. He urges the RBI to reach out and better communicate to ordinary people.

All this is fine but the inflation targeting regime may still need modification. The problem thus far has not been with the inflation regime so much as how the RBI has interpreted it until recently. Although the upper limit for inflation in our regime is 6 per cent, the RBI chose to focus on a target of 4 per cent in practice. As the lower limit of 2 per cent is not particularly relevant now, why not make the mandate more specific by asking the RBI to limit inflation to 6 per cent instead of setting a band of 2-6 per cent?

Perhaps this can be done once the current spurt in inflation subsides and inflation falls below 6 per cent. The time to modify the regime is when the going is good, not when the going is bad. If the government moves to modify the inflation target at a time when the fiscal deficit of the centre and the states is poised to be rise to around 12 per cent of gdp and inflation is running above the limit of 6 per cent, it is unlikely to sit well with rating agencies and investors. At least one of the two closely watched indicators must look good before any change is attempted. 

Inflation must be kept under control. But inflation cannot be allowed to control macro-policy.

America's pandemic bailout is more for corporates than for ordinary folk

America was quick to announce one of the largest fiscal stimuli in the world following the onset of the corona pandemic. Mariana Mazzucato, writing in Foreign Affairs, contends that the government bailout was more for corporates than for ordinary workers.

She writes:

Rather than put in place effective payroll supports, as most other advanced countries did, the United States offered enhanced temporary unemployment benefits. This choice led to over 30 million workers being laid off, causing the United States to have one of the highest rates of pandemic-related unemployment in the developed world. Because the government offered trillions of dollars in both direct and indirect support to large corporations without meaningful conditions, many companies were free to take actions that could spread the virus, such as denying paid sick days to their employees and operating unsafe workplaces.

The CARES Act also established the Paycheck Protection Program, under which businesses received loans that would be forgiven if employees were kept on the payroll. But the PPP ended up serving more as a massive cash grant to corporate treasuries than as an effective method of saving jobs. Any small business, not just those in need, could receive a loan, and Congress quickly loosened the rules regarding how much a firm needed to spend on payroll to have the loan forgiven. As a result, the program put a pitifully small dent in unemployment. An MIT team concluded that the PPP handed out $500 billion in loans yet saved only 2.3 million jobs over roughly six months. Assuming that most of the loans are ultimately forgiven, the annualized cost of the program comes out to roughly $500,000 per job.  

Bailouts that benefit corporates are part of a larger problem in the US. The relationship between government and the private sector is flawed. The government supports basic research that benefits private corporates but the success of those corporates does not translate into any flow of income for the government or any larger public benefit:

The California-based company Gilead developed its COVID-19 drug, remdesivir, with $70.5 million in support from the federal government. In June, the company announced the price it would charge Americans for a treatment course: $3,120. It was a typical move for Big Pharma. One study looked at the 210 drugs approved by the U.S. Food and Drug Administration from 2010 to 2016 and found that “NIH funding contributed to every one.” Even so, U.S. drug prices are the highest in the world.

It is the same story with Silicon Valley companies:

The U.S. Navy did the same for the GPS technology that Uber depends on. And the Defense Advanced Research Projects Agency, part of the Pentagon, backed the development of the Internet, touchscreen technology, Siri, and every other key component in the iPhone. Taxpayers took risks when they invested in these technologies, yet most of the technology companies that have benefited fail to pay their fair share of taxes.

 Mazzucato argues that the relationship between government and the private sector must be set right: socialisation of risk and privatisation of profit is untenable. If the government funds pharma research, this must be reflected in the funding of pharma products. If the government provides financial support to start-ups with guaranteed loans and the like, it must benefit from the upside to these companies.

She moots the idea of a citizen's dividend, as  distinct from a universal basic income. Wherever the state supports private initiative, it must be entitled to the benefits that flow from the initiative. The state can then the share the wealth that accrues to it with all citizens. 

This is a terrific idea. Much of private wealth creation rests on a support system created by the state, whether through land given at a concessional price, tax benefits, public investment in research, guaranteed loans, etc. Wherever there is a subsidy built into wealth creation, the state must get a share of the proceeds. The same goes for companies that are bailed out by public funds.This is not to be confused with taxes that are applicable even where no special dispensation is given by the state.

Do you see any of these ideas in the debate between Trump and Biden?

 

India must fight Vodafone arbitration award

 There is jubilation in many circles over the award at the Permanent Court of Arbitration at the Hague going against India in the matter of the retrospective tax demand of Rs 22,100 crore made by India on Vodafone.

We asked for it, many seem to be saying.  Amending the law retrospectively to deal with the Supreme Court judgement, as the UPA government did, was wrong. Retrospective amendment of laws gave a jolt to foreign investors and is bad in principle.The Modi government must now accept the arbitration award: that would send the right signals to international investors.

Rubbish! As senior lawyer Biswajit Bhattacharya argues in BS today, the SC judgement was wrong, the retrospective amendment was right and India's tax demand on Vodafone is appropriate. 

The issue is capital gains on assets located in India. If the assets are transferred between parties located outside, are capital gains on such assets taxable or not? Bhattacharya points out that if the SC judgement were to be accepted, any two individuals could avoid tax by transferring assets located in India between themselves simply by acquiring non-resident status!

Bhattacharya also raises an important question about how Vodafone approached the matter of acquiring the telecom assets:   

The SC’s ruling that India’s tax authorities had no territorial jurisdiction over this transaction leaves several questions unanswered, given that Vodafone approached the FIPB in India before the transaction. Why did Vodafone await FIPB’s approval before remitting funds from Cayman Islands to Hong Kong if India had no territorial jurisdiction? The Central Board of Direct Taxes (CBDT) is also located in the same North Block where the FIPB office was. How could CBDT, and through CBDT the tax authorities, then not exercise territorial jurisdiction, if the FIPB could?

Bhattacharya also dismisses the contention that retrospective amendment of laws is an evil that governments must avoid:

Critical comments about retrospective amendment are misplaced. It is a settled law that Parliament can legislate prospectively as well as retrospectively, even in fiscal statutes. Many such amendments have been carried out before. Retrospective amendment to FCRA (Foreign Contribution Regulation Act) was carried out by Parliament only to bail out the Bharatiya Janata Party and the Congress, to nullify a judgment of Delhi High Court, which held both political parties guilty of violating the FCRA norms. Why this hue and cry only for Vodafone?

The so-called impact on foreign investor sentiment is bunkum. In the decade since the initial High Court judgement favouring the government, FDI and FII flows have kept rising. It's not as if the retrospective amendment has had foreign investors running away from India.

Bhattacharya seems to suggest that the government was wrong to accept international arbitration. One option appears to be to go on appeal in Singapore. It's for legal experts to suggest other options.

However, we need to be clear that if we are to retain respect as a sovereign nation, the retrospective amendment to the law done by Parliament must be upheld. It's worth recalling that the late Justice JS Verma  had said of the Vodafone judgement that it is one of three judgements "which are best forgotten or allowed to pass" (the other two being the Habeas Corpus case judgement during the emergency and the judgement in the JMM bribery case).  

See also the hard-hitting interview with academic Surajit Mazumdar. 

My latest book, Rebels with a Cause, is out

Happy to share that my latest book, Rebels With A Cause: Famous Dissenters And Why They Are Not Being Heard, is out. It's published by PenguinRandomHouse.

 

I reproduce the blurb:

Democratic societies take pride in freedom of expression. Indeed, the right to dissent and tolerance of diverse viewpoints distinguish a democratic society from a dictatorship. In his new book, Prof. TT Ram Mohan profiles well-known dissenters Arundhati Roy, Oliver Stone, Kancha Ilaiah, David Irving, Yanis Varoufakis, U.G. Krishnamurti and John Pilger to illustrate how, in practice,  dissent tends to be severely circumscribed.  It is only the celebrity status of these dissenters that has kept them from being actively harmed. Through an exploration of the lives and ideas of these personalities , the author argues that, while one may not agree with their positions on various issues, their views merit discussion and debate. Engaging with them and responding to their analyses holds out the prospect for substantive reform within the system. Yet, the dominant elites prefer not to do so, instead marginalizing and even ostracizing dissenters precisely because they find change of any sort threatening.

 Rebels with a Cause is book that asks hard questions to challenge the way we view, and live in, the world—an important book for anyone who refuses to lamely accept the status quo.