Wednesday, May 24, 2023

Rethinking fiscal rules

Public debt ratios have risen since the Covid shock as governments sought to cushion the impact of the shock. Global debt to gdp averaged 96 per cent in 2021. The average for advanced economies was 120 per cent. In 2008, after the Global Financial Crisis, the numbers were 64 per cent and 79 per cent.

The general view, articulated by the IMF, is that the rise in public debt was inevitable and desirable. But… it needs to be brought down quickly. That is, of course, the received wisdom taught in all Macroeconomics courses, namely, the lower the public debt, the better.

It is refreshing to hear a different view from Andy Haldane, former Chief Economist of the Bank of England. Haldane makes two interesting points. One, over centuries, global debt to gdp has tended to rise as governments respond to the need to create more and more public goods. Two- and this is very interesting- even as public debt has risen, the interest costs have fallen. Not quite what you the Macro course would tell you.

How do you explain these? Well, public debt is used often to create assets. These assets generate streams of income over time that can service the debt. So lenders to government look, not just at the debt, but at the assets that the debt creates. What matters thus is not public debt per se but net worth of government, that is, assets minus debt.

Recognising those assets would give us a measure of the true net worth of the government. Just as a company or household would look at their net worth when making investment choices, so too should government. Countries with high net assets have been found to have lower borrowing costs. Bond market vigilantes target poor ancestors, not borrowers.

Moral of the story? The need to create important public goods remains, perhaps, including those relate to climate change. No need to panic over rising debt levels- focus on debt sustainability. As long as debt creates productive assets, physical or human, chances are debt will be sustainable.


Friday, May 19, 2023

India's growth prospects in FY 2023-24


Growth projections for India for FY 24 show wide divergence.

  •  The RBI Governor recently threw his weight behind the RBI forecast of 6.5 per cent
  • The Chief Economic Advisor estimates growth at 6-6.8 per cent with downside risks being greater, meaning growth will be closer to 6 than to 6.8 per cent
  •  The IMF has scaled down its growth forecast for India to 5.9 per cent
  • Dr C Rangarajan, former Chairman, PM’s Economic Advisory Council, thinks we will end up with 6 per cent
  • Many private sector forecasters see growth below 6 per cent, some peg it close to 5 per cent  

What do we make of these forecasts? I guess much depends on whether or not the downside risks materialise. A big one is an escalation in the conflict in Ukraine. Another is further bouts of banking instability in the US and elsewhere. The IMF mentions several other downside risks: higher than expected real interests at a time when debt levels are high; stickier inflation; sovereign debt distress in emerging and developing economies (already seen in Sri Lanka and Pakistan); faltering growth in China; greater retreat from global integration.

The IMF estimates that the probability of global growth going below 2 per cent in 2023 is 25 per cent- this has happened only five times since 1970. (The IMF’s baseline forecast is for 2.8 per cent). That will happen if many of the downside risks materialise. 

My guess is that we will be lucky if India’s growth rate exceeds 6 per cent in FY 24.  

Sunday, May 14, 2023

Interpreting Karnataka poll results



We are seeing all commentaries about the decisive victory score by the Congress in the Karnataka Assembly polls. We need to be careful in interpreting the results. Going by the seats secured by parties in elections, we know, can be deceptive. Small swings in votes can result in disproportionate changes in seats won.

A better gauge of a party’s popularity is vote share. The BJP vote share in Karnataka remains what it was in 2018- 37 per cent-, going by this article. It appears that the BJP lost marginally in some areas, gained massively in Bengaluru and held on to its vote share in the coastal regions. The marginal losses in some places sufficed to change the outcome in terms of seats. What brought about the small change in votes in areas where the BJP lost needs to be analysed.

It does seem that the theories for the outcome that are being put forward- polarisation gone wrong, developmental story winning, leftist orientation of Congress going down well, etc- are premature. We need a rigorous analysis of the outcomes in various regions to tell a convincing narrative.


Saturday, May 13, 2023

FRB review of the failure of Silicon Valley Bank

The US Federal Reserve Board has published a review of the failure at SVB. The lessons are pretty straightforward. Regulation and supervision have to get tighter. Boards have to do a better job. Managerial incentives need to be aligned to risk-adjusted returns, not nominal returns. With respect to boards, I would add: we need an overhaul of the mechanism of independent directors- we can’t leave it to promoters and CEOs to decide who the ‘independent’ directors should be.

The RBI may want to commission a similar review of the failures at IL&FS and Yes Bank. Regulators unilaterally subjecting themselves to public scrutiny is good for good for the regulator’s credibility and standing- and good for bank stability in the long run.

My article in BS, Anatomy of a bank failure

Anatomy of a bank failure

A radical change is necessary in the appointment of independent directors in India in light of the extensive failures in oversight and management of banks in the US




Silicon Valley Bank (SVB) and its holding company, Silicon Valley Bank Financial Group (SVBFG), failed last March. This resulted in the immediate failure of Signature Bank and, with a lag, of First Republic Bank. More mid-sized banks may follow.


The US Federal Reserve Board (FRB) has been quick to commission and publish a review of the failure of SVB. Even more creditable, the review pulls no punches in apportioning blame. The bank’s management failed. The board of directors failed. The supervisor failed. Regulations turned out to be inadequate. Everything that could go wrong went wrong.


The Fed review should be compulsory reading for bankers, bank boards, regulators and supervisors. The report will help drive home an important point: It is futile to expect “market discipline” by itself to take care of banking stability.


Let us begin with management and board failures. SVBFG’s assets tripled in size between 2019 and 2021. Deposits flowed in. The technology sector was booming, so lending expanded rapidly. Any growth in loans that is way above average loan growth in the sector is a recipe for trouble, a point often lost on managements as well as boards. Management does not have the bandwidth to assess risk properly. Internal controls and systems cannot keep pace with runaway growth.  Reliance on volatile wholesale deposits tends to increase. 


Managerial incentives are often linked to profits without adjusting for risk. For CEOs, the temptation to quickly grow the loan book is irresistible. The onus is on the board of directors to apply the brakes.  Rarely does this happen. Boards tend to be mesmerised by CEOs who show dazzling performance for a few years. They find it hard to tell a performing CEO, “Sorry, this is not on.”  


At SVBFG, the board was not even responsive to supervisory warnings. The FRB report remarks acidly, “Moreover, the board put short-run profits above effective risk management and often treated resolution of supervisory issues as a compliance exercise rather than a critical risk-management issue.” That could be said of many boards. 


Starting in July 2022, SVBFG failed its liquidity stress tests repeatedly. Management moved to increase funding capacity but the necessary actions were not executed until March 2023 when it was too late. Management chose to mask liquidity risks by changing the stress test assumptions. 


Interest rate risk too was poorly managed. The bank had breached its interest rate risk limits on and off since 2017. Instead of reducing dependence on short-term deposits, management fiddled with assumptions about the duration of deposits. Hedges on interest rate risk were removed in the interest of boosting short-term profits. Management was massaging earnings by hiding the underlying risks. The Risk Management Committee of the board should have picked up these lapses. It failed to do so, again not a huge surprise. 


The supervisors did not cover themselves with glory either. For governance, SVBFG got a “Satisfactory” rating, despite repeated supervisory observations about inadequate oversight.  The bank had large, uninsured deposits that were volatile, yet managed a “Strong” rating on liquidity. Despite breaching interest rate risk limits repeatedly, it got a ‘Satisfactory’ rating on the item.  Clearly, supervisors in the FRB set-up were hard to displease. Banks in India must pine for such a supervisor; they find the Reserve Bank of India (RBI) almost impossible to please. 


What accounts for these supervisory failures? The report says joint oversight by the FRB and the 12 Federal Reserve Banks is a factor. The Board delegates authority to the Reserve Banks, but Bank supervisors look to the FRB for approval before making a rating change. Getting a consensus is time-consuming. 


But that was not the only reason. In 2018, heightened supervisory standards were made applicable only to banks with assets of more than $100 billion. Moreover, supervisors were under pressure to reduce the burden on banks and to exercise greater care before reaching conclusions or taking action


Finally, there were the failures of regulation. The Dodd-Frank Act, passed after the Global Financial Crisis (GFC), provided for stiffer prudential standards for banks above a threshold of $50 billion. In 2018, the Act was amended to raise the threshold to $250 billion. For banks in the range of $100-$250 billion in assets, the Fed was given the discretion as to what standards to apply. When SVBFG reached the threshold of $100 billion, it was subjected to less stringent regulations than would have applied before 2019. Had the dilution in regulations not happened, SVBFG would have been compelled to enhance liquidity and capital before it was too late. 


The problem is fundamental. The philosophy of “light touch” regulation and supervision hasn’t quite lost its hold on the US system. Multiple regulators and supervisors are another problem. There is also the “revolving door” syndrome -- regulators join private banks, then jump back to the regulator in a senior capacity. The relationship between regulator and banks is too cosy for comfort, which may explain the kindness shown to SVB. 


The RBI, as your columnist argued last month, is well ahead of the regulatory and supervisory curve in the West. Its intrusive approach is a better safeguard for banking stability than the light touch elsewhere. However, supervision can only be a third layer of defence against bank instability. Regulations are the primary layer, followed by the board. The RBI must find ways to get bank boards to do a far better job.   


A radical change would be to alter the way independent directors are appointed at banks. At present, the promoter or CEO has the dominant say in the appointment of independent directors (at both private and public sector banks). The RBI may want to insist that, for instance, one independent director be chosen by institutional investors and another by retail shareholders (from a list of names proposed by the Financial Services Institutions Bureau). Until we have independent directors who are distanced from the promoter and management, it’s unrealistic to expect board oversight to improve. 


The RBI is hosting a conference for bank directors later this month. Here are two suggestions.  One, in the interests of transparency and accountability, the RBI may want to commission a review of the failures at IL&FS and Yes Bank. Two, it may prescribe the FRB’s review of SVB’s failure as one of the “readings” for the conference. It may also include the report of the UK's Financial Services Authority on the failure of Royal Bank of Scotland during the GFC. At least, bank directors can’t say they weren’t warned.





Sunday, April 02, 2023

Whom does the current bout of inflation the West hurt?

The rise in inflation in Western economies has caused a massive transfer of wealth from savers to investors, contends Adam Tooze in an article in the FT. 

Higher inflation means the nominal debt to nominal gdp ratio goes down as the denominator rises on account of inflation. The denominator has risen also because of the rebound in real output post Covid.

Borrowers, namely government and corporates gain, but savers lose. The poor face higher inflation and a loss of jobs. Tooze thinks this can lead to explosive discontent. 

I am not so sure. The only net debt in an economy is government debt (corporate and household borrowings are from other household savers, so the net borrowing on these two counts is zero). So whoever has invested in government debt is a loser. The rich are losers and also the middle class. But the poor are not investors in government debt. They are net borrowers, hence stand to gain from the real value of their debt getting eroded. If inflation can be quickly reined in, they could emerge as beneficiaries from the current bout of inflation. 

The notion that inflation hurts the poor is common. Higher prices mean a higher cost of living. True. But this effect could be overwhelmed by the erosion the value of debt that the poor carry. 


Crisis? What crisis?

 Last November, there was talk of a serious external accounts crisis staring in India in the face. Maybe, not as bad as the one in 2013 but still pretty bad.

The current account deficit, analysts said, could exceed 3.5 per cent of gdp for FY 23. The rupee would be above Rs 85 to the dollar, could even touch Rs 90. It was futile for the RBI to expend dollars to support the rupee- better to simply let the rupee fall and exports do the trick.

Well, less than six months on, little of that has come true. The current account deficit has narrowed and may end up at under 2.5 per cent of gdp, a comfortable position for us. The rupee is trading in the range of Rs 82-82.7. Foreign exchange reserves are at an eight month high of $579 bn.

Lower commodity prices are a factor. Another is that world economic growth has turned out to be better than forecast, with the US escaping a recession in 2023, again contrary to many forecasts. India's gdp growth for FY 2023 is projected to be slightly below 7 per cent

No sign of any crisis, eh?

Recent bank failures

 The question pops up again: what was the board of directors doing at the spectacular bank failures we have seen recently?

An article in FT is informative. Only one of SVB's directors had banking expertise and he didn't sit it on the Risk Management Committee (RMC). The bank's RMC included a director with considerable experience in the premium wine industry. SVB did not have a Chief Risk Officer (CRO) for months and when the CEO appointed one, it was considered a big enough achievement to be a factor in his outsized bonus. At Silvergate Bank, the CRO happened to be the son-in-law of the CEO.

Questions need to be asked also about governance at Credit Suisse as it hurtled from one scandal to another over several years. Even if they are, we are unlikely to get lasting answers. It does seem that the board of directors of a company is amongst the most unreformable institutions in the world.

Monday, February 13, 2023

Consulting as the Big 'Con'


Mariana Mazzucato made a huge splash with her book, The Entrepreneurial State. She argued that there are high-risk, breakthrough ideas such as the Internet that could never have happened with massive funding of the initial creative work. In an interview with FT, she takes on consulting firms, the McKinseys, BCGs and the rest.

Her point is not the usual one about consulting firms not adding much value: as the old chestnut goes, a consultant is somebody who looks at your watch and tells you the time. No, her point is more nuanced. She says that governments are becoming too dependent on consulting firms for ideas. As a result, governments are taking enough responsibility and doing worthwhile work. In the process, the civil services are not attracting the brightest.  

I don’t think that’s true of the IAS. The beauty of India’s competitive exams is that the talent pool is so incredibly large that when you are looking to fill, say, 150 slots out of half a million applicants, you are bound to get incredibly good talent. The IAS, in my view, still gets some of the best talent in the country. But that could also be because our government hasn’t developed the UK sort of dependence on consulting firms! Or, there is so much of work to be done in government that if even if you farmed out work to consultants, there would be a great deal left for government to do.

Friday, February 10, 2023

Four trends that will impact the Indian economy


I identify four broad economic trends from which there is no escape for the Indian economy:

1. Government capital expenditure will drive the economy in the medium-term.

2. 2. High fiscal deficits are here to stay.

3. 3. Inflation will be higher than before

4. 4.  Self-reliance and import-substitution are a reality

The macroeconomic outcomes that we can realise will be constrained by these four trends.

More in my BS article, Four economic trends that will impact India.

Four economic trends that will impact India

There are four broad trends that will impact the Indian economy in the years to come. The Budget for 2023-24 affirms these trends.

1. Government capital expenditure will drive the economy in the medium-term: The latest Economic Survey underlines the fact that government capital expenditure has risen from a long-term average of 1.7 per cent of gross domestic product (GDP)in the period FY09 to FY20 to an estimated 2.9 per cent of GDP in FY23. The latest central Budget expects capex to rise to 3.3 per cent of GDP in FY24.


This points to an inconvenient fact: Private investment has remained sluggish and the government has had to compensate. The behaviour of private investment is not unique to India. It is part of a trend that is seen in emerging and developing economies (EMDEs). As the World Bank’s Global Economic Prospects (2023) points out, investment growth in EMDEs in 2022 remained about 5 percentage point below the 2000-21 average, and nearly 0.5 percentage point below in EMDEs excluding China. 


The World Bank does not see private investment returning to the level suggested by the pre-pandemic trend through 2024. It lists several factors responsible for the slowdown in investment growth in EMDEs: Slower output growth in 2010-19; lower commodity prices; lower and more volatile capital inflows to EMDEs; higher economic and geopolitical uncertainty; and a substantial build-up of public and private debt. Many of these factors apply to India.  


The government sees a sharp rise in capex in FY24 as boosting output growth. This overlooks the fact that the fiscal deficit is projected to decline by 0.5 per cent of GDP in FY24. We have a withdrawal of stimulus, something that is contractionary in nature. 


True, the composition of expenditure has shifted even more towards capex, and this is expansionary. But this effect can overwhelm the contractionary effect of a fiscal deficit decline only if the rise in capex is greater than the decline in the fiscal deficit.  In  the budgetary projections, the rise in capex is 40 basis points whereas the decline in the fiscal deficit is 50 basis points. The net effect will, therefore, be contractionary


2. High fiscal deficits are here to stay: Analysts cheered the finance minister for sticking to the fiscal deficit of 6.4 per cent for 2022-23, and projecting a fiscal deficit of 5.9 per cent for 2023-24. The figure for 2023-24 is a budget estimate. If the Ukraine conflict escalates and the global situation worsens, government subsidies (which have been pruned in FY 2023-24) will rise and we could be back to square one. We must also expect sops to be rolled out in the run-up to elections in 2024.  


The fiscal situation can be turned around in a fundamental way only if the tax-to-GDP ratio goes up significantly (say, above 12 per cent of GDP) or if capital receipts from disinvestment rise significantly or both. On either count, the outlook is not promising. The tax-to-GDP ratio   is estimated at 11.1 per cent for 2023-24.  The peak in the past decade has been 11.4 per cent.  


As for the proceeds from disinvestment, the Economic Survey notes that total proceeds from sale of equity in public sector units (PSUs) amounted to ~4 trillion in the eight-year period from 2015 to January 2023, or an average of ~50,000 crore in a year. Strategic sales have yielded a mere ~69,412 crore in the entire period. It does look as though the Fiscal Responsibility and Budget Management target of 3 per cent will remain a distant dream. 


After the global financial crisis and then the pandemic, we are seeing a rise in government deficits and public debt everywhere. India is no exception. If anything, the rise in debt to GDP ratio from 81 to 85 per cent between 2005 and 2021 looks modest in comparison with the increases elsewhere-- 66 to 128 per cent in the US; 39 to 95 per cent in the UK; 26 to 72 per cent in China; and 69 t 93 per cent in Brazil. India’s public debt position looks even better when we take into account the fact that 95 per cent of the liabilities are domestic, and we have the growth-interest differential working in our favour.


3.Inflation will be higher than before: High fiscal deficits can be expected to translate into high inflation. That apart, de-globalisation will happen in a greater or lesser degree. The movement may be gradual, but the direction is clear enough. 

Globalisation was about procuring goods and services at the lowest cost from almost anywhere in the world. Princeton historian Harold James noted recently that there is a historical pattern of globalisation driving disinflation. Alas, it appears the trend towards globalisation is now being disrupted.

Post-Covid and post-Ukraine, every country is reassessing its extent of dependence on outside suppliers from a range of goods and services. The US and its allies are determined to reduce dependence on China to the maximum extent possible as the containment of China has become the West’s strategic priority. 

There has been serious academic discussion in the US about revising upwards the inflation target of 2 per cent so that monetary policy has more room for manoeuvre in the downward direction. In India, the inflation target of 4 per cent threatens to become largely notional. We would be thankful now if inflation falls below 6 per cent.  

4. Self-reliance and import-substitution are a reality: For the reasons cited in (3) above, “make at home” will gain in importance. This will be especially important for leading economic and military powers. As India moves towards becoming the third largest economy in the world with matching military clout, a lurch towards greater self-reliance is inevitable. We need not be unduly apologetic about this trend: We are only falling in line with a worldwide trend. The adjustments in tariffs in the recent Budget, analysts have noted, are aimed at helping domestic industry.

It’s no use bemoaning the trend towards protectionism in various economies, including India. It makes no more sense instead to make a success of schemes such as Production-Linked Incentives. We must find ways to limit abuse of discretion in industrial policy. We need to monitor the effectiveness of the PLI scheme using appropriate metrics. Industrial policy will be integral to economic policy in the years to come.

 Macroeconomic outcomes in the coming years will be governed by the four trends outlined above.