Thursday, 11 January 2018

The 6.5% warning

Indian Express, 11th January 2018

Almost all steps in the strategy to revive investment are likely to be slow and painful. There are no shortcuts

The GDP forecast for FY 2018 of 6.5 per cent does not come as a surprise. The introduction of a Goods and Services Tax, even in its cleanest and simplest form, would have inevitably led to disruption in any economy. In India's case, multiple rates and a complex structure have made compliance cumbersome and created gaps in the supply chains. As the government simplifies the GST regime in response to the difficulties being faced on the ground, this problem will likely get solved. The bigger challenges for the economy are the problems that have just begun to be solved.

The central puzzle is the decline in investment. Investment did not start declining immediately after the global financial crisis in 2008, but with a lag. For a couple of years, the economy was held up by expansionary fiscal and monetary policy, and the momentum of the previous years. But since 2012, the demand shock seems to have caught up with us. Investment in the Indian economy has declined from 34.3 per cent of the GDP in 2011-12 to 27 per cent of the GDP in 2016-17. The first advance estimates on national income show that investment as a per cent to GDP has further fallen to 26.4 per cent in 2017-18.

During these years, a number of solutions have been tried to revive investment, but with limited effect. First, the decline was understood to be a consequence of the policy paralysis under UPA 2. A large and increasing number of stalled projects was seen to be the reason for the slowdown in investment. There was consequently an attempt to address this issue by reviving stalled projects. Even though the number of stalled projects was reduced with active government intervention and inter-ministerial coordination, the difficulties of private investment did not go away. Stalled projects were perhaps an outcome of underlying problems and not the cause. Therefore, addressing them did not raise the growth of private investment. The outcome to watch for tracking investment is projects under implementation. These started declining in 2011 and have still not picked up after six years.

Next, it was felt that private investment could be increased by raising public investment. Even though the government's ability to raise capital expenditure was limited, there was expected to be a crowding-in effect, and the increase in public investment was expected to lead to an increase in private investment. This strategy had limited effect. Public investment increased but at a much slower pace than expected. The government’s ability to write good contracts and give out projects was limited by bureaucratic hurdles, government contracting systems and procurement rules.

Meanwhile, bank financing had also run into trouble. Banks had lent to companies who were no longer returning their loans or paying interest. Corporate debt restructuring, that gave borrowers additional time to pay back after the crisis, had not helped. Bank money was stuck and they could no longer lend. Credit growth had slowed down. The way out was sought in going after the bad guys or the "wilful defaulters". The others were to be given a longer rope. This strategy did not get money back to banks.

First, it was very hard to identify the bad guys who had run away with the money. Even when the Vijay Mallyas were identified, the banking system did not get the money back and bank lending did not pick up. The good guys who were given time to return the money kept pushing repayment dates further, and they were given new mechanisms to keep kicking the can down the road. Banks failed to recognise poorly performing assets as non-performing and the regulator was lax. The net result was pretty much a bankrupt banking system stuck with bankrupt companies.

The logjam can no longer be ignored. The Bankruptcy Code and the Financial Resolution and Deposit Insurance Bill are a strategy for addressing this problem. They are critical elements of trying to untangle the mess we are in and to address the huge problems being faced today in the banking and corporate sector that have brought investment to a sharp decline. These are not popular measures. Nor are they quick-fixes. The 12 cases that the RBI has sent to the the bankruptcy process could lead to haircuts and losses that cause a number of banks to become unable to meet their capital adequacy requirements in the coming quarter. To prevent this from happening, Rs 2.11 lakh crore is being put into bank recapitalisation. This money could well have been spent on infrastructure or public investment. But until a better plan is ready, the immediate need to allow exising banks to function is the first step.

However, looking forward, as bankrupt companies and bad loans will be resolved by the bankruptcy process, bank losses will rise and putting budgetary resources into loss-making public sector banks will become increasingly infeasible. The creation of a Resolution Corporation will allow banks to be sold to other buyers in an orderly way. The FRDI bill is currently being examined by a Joint Parliamentary Committee and is likely to be passed after taking into account the fears and concerns.

Another critical requirement for investment growth is the availability of non-bank finance. There has been discussion about a corporate bond market that could provide funds to industry, particularly big industry. Yet, no country has been able to develop a liquid and well-functioning corporate bond market without a risk-free benchmarket rate provided by a government bond market. The creation of a well-functioning government bond market with a public debt management agency and integration with equity markets was proposed in the March 2015 Budget. This proposal was rolled back to give the RBI time to work with the Ministry of Finance on a transition plan. As a critical element of facilitating finance for investment, this work needs to be prioritised.

Almost all the steps in the strategy to revive investment are likely to be slow and painful. A sustained pick-up in investment and growth can be expected only once these essential elements are in place.

Tuesday, 31 October 2017

Extend and pretend

Indian Express, 31st October 2017

Banks can play that game no more. But recapitalisation is not the reform that is needed to prevent a recurrence

The problem of rising non-performing assets of banks has been simmering beneath the surface for many years. Until now, it was possible to sweep bad news under the carpet. But the pressure arising from bad loans going through the bankruptcy mechanism has made it difficult to continue the game of extend-and-pretend. Recapitalisation of banks is, however, not a reform. It uses taxpayer money to cover up the failure of institutions. To prevent a recurrence of such failure, it is important to reform not just governance, but also regulatory oversight.

The problem of hidden bad assets is pervasive across the entire banking system. Both public and private sector banks are part of the story. If one bank had been undertaking fraudulent accounting practices and hiding problems, it could have been blamed, and its management punished, as in the case of Satyam and the conviction of Ramalinga Raju. If the problem was limited to public sector banks, we would have found solutions in their governance. Private banks have also been hiding bad assets. The present NPA crisis appears to be as much a failing of the banking regulator. For many years, despite its unquestioned powers to regulate, supervise and inspect banks, the regulator did not take action against banks that were hiding their bad assets. Instead, it proposed one loan restrucuturing scheme after another. None of the schemes, like CDR, SDR, S4A succeeded and stressed assets grew in number and value. It is only now, when credit growth has collapsed, that solving the problem cannot be postponed further and the regulator has become strict.

There has been a lot of discussion about restructuring public sector banks. However, this misses the point that private sector banks are also in a similar situation. The question to ask is: Why did the banking regulator fail to take action against banks that were hiding bad loans? The RBI is a regulator that interferes with bank operations more than any other banking regulator in the world. Given its policy of giving hardly any new bank licences, the RBI has only a small number of bank books to examine. So why did it fail in this core function?

A charitable explanation could be that its staff is of poor quality. It is ill-equipped to inspect bank books. Why did the RBI not see the problems, like late payment of interest and principal, evergreening of loans, mechanisms that banks created to keep bad loans from been classified as such until 2015? Many regulators, particularly abroad and some in India like SEBI, hire practitioners from the industry to be part of supervision teams. Is it that the RBI does not have adequate lateral entry and depends on people who have not been on the other side, and thus keeps getting outsmarted?

A second, less charitable explanation could be that bank inspection did reveal the bad asset problems. But the inspectors kept quiet. Finance Minister Arun Jaitley has said the problem was hidden under the carpet till 2015. In other words, the regulator knew that there were bad assets, but did not press upon banks to declare them non-performing. The regulator did not take action when banks continued to extend-and-pretend. Loans were not declared NPAs despite non-payment of interest or principal. Bank inspectors looked the other way when banks gave additional loans to defaulting clients to service these loans. If this was the problem, should there not be a question about why the regulator behaved in this manner? A bad loan is a rapidly depreciating asset. The RBI was the only authority with oversight over banks, and allowing extend-and-pretend increased the cost to the taxpayer of recapitalising banks. Who was responsible, who is accountable?

Whatever the correct explanation - incompetence, complicity or the attempt to hide its own inadequacy - there is no question that the banking regulator, by failing to do its job, has burdened the taxpayer with higher costs. The cost of solving the NPA problem has grown every year that the RBI has hidden it, and the burden on the taxpayer has increased.

The RBI has an annual spend of Rs 13,000 crore at present. It is the only regulator that is not subject to a CAG audit. In the name of independence, the RBI has become unaccountable. All institutions that spend public money need to be accountable, and one that fails in its job cannot be excused for any reason. A mistake as big as one requiring Rs 2.11 trillion of taxpayer money should be followed by an analysis of the failure of the government agency explicitly tasked with preventing this very situation.

In view of the earlier PSB recapitalisations and bank regulatory failures in the past, the Financial Sector Legislative Reforms Commission (FSLRC) had proposed changes to the governance, regulation making, supervision, inspection and data collection in all regulators, including the RBI. The FSLRC also proposed a resolution corporation with powers to inspect banks. While the Financial Resolution and Deposit Insurance Bill that aims to create a resolution corporation for banks has been tabled in Parliament, it does not give it the power to inspect banks and thus to create checks and balances to the RBI’s power. Without additional supervision, and without checks and balances, the RBI will continue to be the only supervisor of banks. The resolution corporation will step in only after the RBI declares a bank has failed.

Regulatory failure across the world has led to changes in regulatory regimes, in laws and in institutions. Creating checks and balances is a necessary element of the reform process. Independence and accountability are two sides of the same coin. Regulators must have both.

In conclusion, in the discussions about the reform that should accompany recapitalisation, it is important to remember that it is not enough to reform public sector banks. The problem of hiding NPAs is also present in private sector banks. The failures of banking regulation must be addressed and checks and balances created.

Friday, 1 September 2017

Maximum pain

Indian Express, 1st September 2017

Objectives of demonetisation could have been served better by doing a cost benefit analysis.

The RBI Annual Report reveals that almost all demonetised notes have been returned to the central bank. This number does not include the old notes with District Central Cooperative Banks for the short window when they were allowed to accept deposits. It also does not include the notes within Nepal. The shortfall of Rs 16,050 crore between the notes in circulation when the notes were demonetised and those that were returned, could therefore also be made up once these notes are returned to the RBI.

It should come as no surprise that almost all the notes have been returned, including the stock of black money held as cash. To the extent that it was possible to exchange money legally, individuals did so. When cash limits for withdrawal made it difficult, friends and families participated. The inconvenience of long queues was overcome by household staff. A private company offered booking of "chhotus", who would stand in long queues for people for Rs 90 an hour until their turn came. Bank employees were averse to being unhelpful to regular customers and found ways to serve them. Innumerable ways were found to work around the changing rules of exchange, cash limits, indelible ink and specified uses of old notes.

Those who could not exchange money legally found money changers. Innumerable anecdotes, media reports and arrests of bank staff tell stories about how this was done all over the country. When the government announced that old notes could no longer be exchanged, but only deposited, new ways of changing the stock of unaccounted cash emerged. Individuals with bank accounts, including Jan Dhan accounts, and companies showing cash accrual from sales came into business. Large amounts could be laundered through this route as it did not involve immediate cash payouts by banks, since cash shortages still persisted with the RBI and banks scrambling to remonetise the economy.

It was to be expected that even if people have to pay tax on their hoarded cash, and a change fee, they would prefer to do that rather than lose the whole amount. Data from Prowess, a database of companies in India, shows that in the quarter of demonetisation, when purchasing power had fallen sharply, net sales by companies rose significantly. At the same time, the number of tax payers and tax collections rose. The tax department is said to have found thousands of shell companies which were possibly engaging in the activity of depositing money in their accounts during the demonetisation period, claiming that it was cash from sales. This provided a means for laundering money.

The total currency in circulation, according to the RBI’s annual report, is about Rs 2 lakh crore short of the pre-demonetisation period. This is partly due to the increase in focus on printing of lower denomination currency notes. Initially, the RBI had focused on printing the Rs 2,000 notes to rapidly remonetise the economy. In addition, there could be some reluctance to hold cash. The replacement of cash transactions by digital transactions, the slowdown in small-scale industry, in the rural economy, construction and other informal segments of the economy could also lead to somewhat lower demand for cash. However, it is less probable that the cash of black money holders has not been withdrawn because they are unlikely to leave that in the bank accounts of the money launderers for long. It might have partly been settled for bitcoins, gold, or similar assets that are difficult to trace.

There is no doubt that those with holdings of unaccounted cash lost some of their wealth in the process of laundering it. To some extent, taxes were paid on it in the process of legitimising it. But in addition to that, illicit wealth was redistributed from black money holders to money launderers. Whether the money launderer was a company owner, a bank employee or a Jan Dhan account holder, there was now a need breed of criminals with wealth obtained from illegal means. The total reduction in black money was therefore much smaller than what might have been envisaged.

International evidence suggests that few countries address the problem of black money by demonetising their currencies. If the problem is large-scale crime, corruption, bribery, bureaucrat-politician nexus, rent seeking, tax evasion etc. the answer lies in reforming the criminal justice system, law and order, administrative reforms, bringing transparency in the functioning of the state and rationalisation and simplification of the tax system. In this context, the GST will be a far more effective mechanism to bring down tax evasion in indirect taxes considering the greater incentive for compliance that its design holds.

The real rationale for new notes by the RBI is a rather innocuous paragraph hidden away in its Annual Report. It says: "As a standard international practice, the design and security features of banknotes are reviewed periodically. In line with this practice, a new series (Mahatma Gandhi New Series) of banknotes in new design, dimensions and denominations, highlighting the cultural heritage and scientific achievements of the country, was introduced during the year. As part of this process, banknotes in the denominations of 500 and 2000 were introduced on November 8, 2016. New design notes in other denominations are due for phased introduction." (Section VIII.15, RBI Annual Report 2016-17).

The best way of achieving this objective would have been to slowly replace old notes with new ones, giving the public adequate time to exchange and deposit old notes, as is also "standard international practice". The outcome would have been the same. The pain would have been much lower.

This episode in India's policy-making highlights an essential tenet of policy-making — the need for a cost benefit analysis. For any objective that is to be achieved, we need to examine various policy options and analyse their costs and efficacy. For an economy on the path of reform, with many more reforms still to come, long-term sustainable impact can be achieved only when we strengthen the policy-making process as well.

Friday, 3 February 2017

Not with a bang

Indian Express, 2nd February 2017

FM springs no surprises. Nor responds adequately to slowdown in private investment.

Budget 2017 took place under the shadow of demonetisation. What would the follow-up actions be, especially as the outcomes from demonetisation have been disappointing compared to its stated objectives? The budget has proved to be a quiet affair. We are left with relief that erratic actions have not been taken. At the same time, there were few steps that would address the biggest concern about the economy - the slowdown in private investment.

Before the budget speech, there were several scenarios which were being talked about. Would the budget propose other radical measures like a banking transaction tax or the removal of income tax proposed by Artha Kranti? Would the budget try to soothe demonetisation’s pain by sending transfers and tax breaks to the affected? Would the fiscal deficit be increased to alleviate its contractionary impact?

The demonetisation experiment was a negative shock to the economy. Some people were proposing that this should be offset by a fiscal expansion. The finance minister (FM), however, stuck to a modest fiscal deficit. This makes sense for many reasons. First, a larger fiscal deficit could have hurt India's credit rating. A fall in ratings could have lead to a flight of capital and a rupee crisis. Second, providing a fiscal stimulus would be tantamount to accepting that the negative demonetisation shock has consequences beyond the present quarter. This may not be something the government is ready to admit. In terms of providing a positive shock by expanding expenditure, the capacity of the state to spend funds effectively is limited. The budget speech did well in not announcing big subsidy programmes. There was a sharp increase in the expenditure of MNREGS. This may be consistent with the increased utilisation of MNREGS owing to demonetisation that appears in the initial data. It has to be kept in mind, however, that the prime minister’s speech on December 31 announced many traditional subsidy programmes.

The overall emphasis on subsidies is larger than meets the eye.

At a conceptual level, perhaps demonetisation and the associated political strategy is more about being anti-rich than being pro-poor. In the past, populism in India has involved inventing subsidy programmes that help the poor. This government has tried to make poor people happy by pointing to the distress of the rich. Perhaps this would imply that the budget would also take actions which could be positioned as being anti-rich, such as raising tax rates or avoiding reforms. There could have been a number of measures that fitted the bill, such as a wealth or inheritance tax. It is not clear what the impact of these would have been. The FM proposed a surcharge on income between Rs 50 lakh and Rs 1 crore.

When faced with economic difficulties, another way through which fiscal policy can be expansionary is to cut taxes. One long-standing area for Indian fiscal reform is bringing down the corporate tax rate. In Union budget 2015, the FM promised that the Indian corporate tax rate will be brought down to 25 per cent. One concern for not doing this for the corporate sector may have been the risk of being called pro-rich. Another may have been the uncertainty that removing exemptions could have introduced at this time. The rate could not have been cut for large corporates that contribute to most of the corporate tax collections, without removing exemptions, or it would have led to a dip in revenues, something the government cannot afford at this point.

A compromise has been achieved by proposing a lower, 25 per cent tax rate for small companies whose income is under Rs 50 crore per year. At a political level, this can be seen as reaching out to small businesses. One can also hope that they would help to improve compliance by smaller companies.

Similar moves are visible in personal income tax, where tax rates were cut at low incomes and increased at higher incomes. These moves are consistent with the populist, anti-rich stance. Respect for Indian policymaking capacity was at a low after demonetisation. Expectations for the budget speech were low. The pessimists expected an escalation of erratic measures crafted by non-experts. The prevailing mood seemed to support doing things that were bold and that no reasonable country had tried before. Fortunately, the budget did not propose a universal basic income, a banking transaction tax, a cash transaction tax or any other untested idea.

In terms of institutional reform, the budget speech was necessarily silent on the big story: The Goods and Services Tax.

A sound GST is one with a low single rate, comprehensive coverage and a single administration. Many compromises have already been made which ensure this will not come about. The extent to which a sound GST is delivered will have a major impact on the coming years.

On financial sector reform, some old policy initiatives are gradually going towards execution. The abolition of FIPB was long overdue and is a welcome step. The Resolution Corporation will deal with the failure of financial firms.

In summary, while the FM should be given brownie points for staying on the conventional path and not giving any big surprises, he also did not respond adequately to the serious slowdown in private sector investment India has seen in recent decades.

Monday, 16 January 2017

Reserved Bank of India

Indian Express, 14th January 2017

Demonetisation showed India's central bank is too opaque. Its decision-making must be open to scrutiny.

The RBI board's decision to recommend withdrawal of legal tender of high denomination notes after a short board meeting is seen as a loss of independence of the RBI. The recommendation was based on advice by the government that the RBI Central Board should consider such a decision. The RBI board was within its powers to turn it down. It could have directed the management to give it a report on the costs and benefits involved and taken a considered decision in its next meeting. Why did it not do so? Why could the government take the RBI board for granted?

To figure this out, we need to look at how the RBI Central Board normally makes decisions. As an example, we consider how the RBI Central Board decides the annual expenses of the RBI; a relatively important decision about spending public money. The RBI annual report shows the RBI’s annual expenses in 2014-15 were Rs 13,356 crore. These are comparable to the annual expenditure of many states in India, and many times bigger than that of most central banks and regulators in India and abroad. Nearly a third, or more than Rs 4,000 crore, is spent on RBI staff salaries, superannuation, housing, maintenance, directors’ fee and board meeting expenses. Such a large use of public money requires adequate scrutiny.

The board would discuss and approve the expenses and fulfill its role of controlling excessive expenditure by the management. However, there is no evidence available that the board even discusses this enormous annual spend of the RBI. Further, there is no evidence that the board looks after the public's interest in the event that there may be a conflict with the interests of the management. This is something the Board would have been expected to do. The decision seems to be taken mainly by the management - without the scrutiny of the Board.

How could such an arrangement be possible in today's India? The answer lies in the text of the RBI Act. In 1934, India's British rulers did not see a role for defending public interest which could be in conflict with the interests of the RBI management - the sections of the Act relating to the functioning of the Board have not been amended even after Independence. Through regulations made by the Board (Regulation 15 of the RBI General Regulations), the board created a "Committee of the Central Board" to which it delegated all its powers. The management may invite a couple of directors to meetings of the Committee, based on whichever directors happen to be in Mumbai at the time. This Committee can meet often and take all decisions that are then approved by the Board - in effect, the RBI Central Board has abdicated its responsibilities to the people they were supposed to have oversight over, that is, the management.

A normal governance practice is to create committees of a board with specific mandates and come back to the board for decisions, rather than take decisions. All decisions are taken by the board. In the case of the RBI, all the general powers of the Central Board have been delegated to the Committee of the Central Board - the Committee of the Central Board virtually can do everything that the Central Board can, under the RBI Act. This defeats the spirit of collective decision-making at the Central Board-level and circumvents the necessity of obtaining votes of the majority of members of the Central Board. The minutes of the Committee are placed before the Central Board; this serves little purpose as decisions are already taken and members did not participate in them. The Central Board effectively becomes responsible for all decisions of the Committee without deliberations - while the Committee has no accountability on how it discharges its duties.

The regulation that empowered this Committee to transact all the business of the Central Board was made in 1949. For decades, the RBI board has functioned in a manner in which it did not deliberate on the most important decisions of the functioning of the RBI. This suited the management, which did not have public accountability in this unusual set-up. The management's functioning has consequently become a black box with no scrutiny. The Board functions in a manner that would not be acceptable even for a private company as it would violate company law. Today, Parliament may find fault with the demonetisation decision and blame the RBI for not asserting its powers or the governor for not doing his job properly. But if the Board continues to function in this manner, the problem will remain.

A related issue is that of transparency. The RBI does not make the Board agenda or minutes public. This lack of transparency is not just about this episode, when an RTI enquiry about Board minutes was turned down. Even the minutes of Board meetings held five years ago are not made public. If the Board was required to make its proceedings public, would it have continued to behave in this manner or would public scrutiny have prevented such functioning?

This takes us to the question of what is gained by transparency. Why are the agenda and minutes for board meetings of regulators or central banks in India and abroad made public? In the minutes, only a few specific decisions, such as those related to specific companies or trade secrets that the law prevents regulators from revealing, are held back. The answer lies in the understanding that along with transparency comes autonomy. When participants know that discussions of the meeting will be made public, they, as well as those who may be sending letters or advice to the Board, behave more responsibly. This reduces the chances of the Board being pressured or taking hasty or irresponsible decisions.

Parliament must examine in detail the functioning of the RBI Central Board. The RBI must be required to make public minutes of all past meetings of the Central Board. The agenda of every meeting should henceforth be public. If there are to be any exceptions based on national security, it is Parliament that should decide. The Board must not be allowed to abdicate its responsibility. Unless Parliament amends the law and enforces a well-functioning Board, the RBI will continue to be a weak institution and fertile ground for further mistakes.

Friday, 9 December 2016

Crossing the chasm

Indian Express, 9th December 2016

When you wish to influence the behaviour of millions of people, consumers, businesses there has to be a change in the policy framework.

The RBI's Monetary Policy Committee wisely decided not to cut policy rates in its meeting on December 7. Though the economy has witnessed a sharp negative shock with a drop in consumer demand, a rate cut can do little to counter the shock of demonetisation. A policy rate decision is usually expected to have an impact on inflation in one to two years. By then, it is hoped that the impact of this negative demand shock will be over. Moreover, measuring the impact of demonetisation on inflation and the GDP is difficult as the story is still playing out. A bad, but not unlikely, scenario is that demonetisation increases uncertainty in the policy environment, and its effects go beyond the immediate demand reduction due to cash shortages. Consequently, it could lead to a postponement of investment revival by a few years making it difficult to forecast the GDP. Consequently, monetary policy-making too has gone into wait and watch mode.

The decision to keep the rate unchanged is also good as an attempt to improve public perception of the RBI. Demonetisation and its handling, as well as the RBI's insistence that the process was carefully deliberated, adequately prepared for, and that there is ample cash with banks, has undermined the public's confidence in the RBI's capabilities and its commitment to the inflation target. Deputy Governor R. Gandhi's statement after the monetary policy meeting raises, rather than answers, questions about the RBI's competence. Most are unconvinced that the RBI board's recommendation to the government to demonetise was based on independent and technically sound analysis.

As a way out of the shortage of cash, government and the RBI have appealed to the public to adopt electronic payments. Indeed, it increasingly appears as if that, rather than black money held in cash, was the main objective of demonetisation. One point often made in the current debate is the difficulty in doing so as half the Indian population is unbanked. This is an important obstacle in the adoption of electronic payments. The pertinent question, however, is: Why does half of India's population not have bank accounts?

Most of India lacks bank accounts because we have tried to apply a command and control approach to banking policy. The lack of a competitive banking system meant that banks themselves were not inclined to open rural branches and ask customers to open bank accounts. Instead, beginning with the nationalisation of banks, it has been a government initiative for many decades. Banks have been given targets. Pushing public sector banks to open branches, and then pushing them to open accounts for the poor has not been a successful strategy. We did not create a competitive banking system. New commercial bank licences have been rare, barely two per decade. Foreign banks are not allowed to open more than 20 branches a year.

No doubt, in these difficult days without cash, there will be some movement to digital payments. Growth figures, given today's tiny base, will look large. But even some of this may be temporary. Permanent adoption of electronic payment systems will depend on the ease of payments and the charges to be paid for these services. Government has made digital payments free till December end to alleviate the cash situation. At some point beyond that, payment service providers will be allowed to charge for their services otherwise they will shut down the service, killing the whole cashless project. It has been reported that Visa, Mastercard and RuPay will altogether lose Rs 1,000 crore in November-December. Regardless of the accuracy of the amount reported, this is not a sustainable model.

Electronic payments have to be easy to adopt. There are plenty of models around the world to learn from. In some countries today, person to person payments are generally made digitally. Having effectively blocked such payments so far by onerous KYC norms and other restrictions, even the young who had the literacy, the means and the attitude to adopt e-payments, have not done so to the extent desired.

Unless the RBI ensures that all electronic payment systems and e-wallets are inter-operable, we could be creating a monopoly. Today the payments regulator, the RBI, prevents a Paytm customer from paying a MobiKwik customer. This is unlike the TRAI that pushes telecom companies to accept calls that originate from other telecom providers. A telecom company cannot refuse to accept incoming calls and force the customer receiving the call to subscribe to its service. However, a payments provider requires the customer receiving payments to download its app and become a subscriber.

In markets with such network externalities, one of the service providers is likely to emerge as a monopoly, unless the regulator steps in. This is undesirable for a number of reasons. It could leave customers vulnerable to higher charges later, which may again reduce the adoption of digital payments. Second, it would reduce the incentive of the monopolist to constantly innovate as he will not be facing competition. Third, it will create systemic risk as it will make the system vulnerable to the health and electronic infrastructure of one provider. If the provider fails, the whole system can crash and again the economy can come to a standstill.

If the government wishes to push faster for a cashless economy, policy and regulation need to focus on competition and innovation. The RBI has been promoting bank-centric payment systems in an economy where banks don’t even compete to get customer accounts. It is no surprise that neither banking nor payments have spread to the entire population.

When you wish to influence the behaviour of millions of people, consumers, businesses there has to be a change in the policy framework from targets to one that works through incentives. In this case it has to be about incentives of banks, of payment service providers, of the payments regulator etc. Pushing the economy into cashlessness cannot be forced by putting Rs 2,000 notes in the hands of the public so that people use electronic payments from lack of choice, where card companies provide the service at a loss and where some wallets could emerge as monopolies, from sheer neglect or not putting a competitive policy framework in place. If we are moving towards the goal of cashlessness, a focus on technology and neglect of an appropriate competitive regulatory framework will be short-sighted. The policy framework must be based on competition, interconnection and consumer protection. Policy work and committee processes have been working on cashlessness for many years. This work needs to go into the government's next steps.

Friday, 11 November 2016

Show me the money

Indian Express, 11th November 2016

While the ban may address the problem of the stock of black money in cash, the question is will it encourage people to disclose all income and start paying taxes on it? (Source: Reuters)

The sudden and dramatic announcement by the prime minister banning Rs 500 and Rs 1,000 notes issued by the Reserve Bank of India has a number of objectives. Among them are tackling counterfeit notes, curbing black money and restricting finance for subversive activities. While progress will be made by suddenly making the present high denomination currency illegal, we need many more steps before the desired objectives can be fully achieved.

One of the main objectives of replacing old currency notes by printing new notes is to tackle the problem of fake currency notes in circulation. In India, there is fear that counterfeit currency is being used for financing terror as well as other subversive activities. If security features of the present notes are weak and there is rampant counterfeiting, there is a need to replace these with new notes that have better security features. Usually, this is done gradually. So, for instance, the RBI could have started issuing new Rs 500 notes, allowed old notes to be exchanged for new ones and issued a deadline after which the old notes would not have been legal tender.

This is typically the strategy followed by most central banks, who are, in general, in a constant battle with counterfeiters. Curbing counterfeiting of internationally accepted currencies like the US dollar, which is used all over the world for legal and illegal activities is supposed to be a constant challenge.

In India, the problem of fake rupee notes has been noticed for many years. It has been difficult to estimate the size of the fake notes in circulation. It is not known whether the counterfeiting is done in India or across the border. Currency notes with better security features are certainly welcome, though it is not obvious that such a sudden move would make a big difference to this objective. It could have been done slowly with banks not giving out old notes until the last hour.

Then, the objective of curbing black money. Black money is money that has not been declared as income to the income tax authorities. It is not necessarily obtained from crime or corruption. It may be acquired by not showing the output of a factory and not paying excise on it. All black income is not held in cash. For instance, it may be in foreign bank accounts. Similarly, all cash is not black income. Legitimate businesses deal with large amounts of cash. Petrol pumps, white goods dealers, textile merchants and jewelers often have large cash holdings by the end of the day with many consumers paying in cash.

Cash will either have to be exchanged by the holder at a bank himself or through someone. For some days, it will be disruptive for business. It would not be surprising if, in some time, a black market pops up to exchange old notes for new notes, thereby converting black money into white. This could be in the 50-day period in which the old notes can be exchanged with new ones. There would, no doubt, be a discount, if this happens.

But the ban will certainly hit those who are holding black money in cash. Corrupt bureaucrats, politicians and many more with piles of cash must be wondering how to handle the situation and how long to wait before they try to solve it. Since the present high denomination notes are going to be replaced by new notes, it is not that cash will no longer be used for corruption and storing black money - though it is likely that dollars, gold or diamonds could become more popular for such illegal purposes due to the fear of such a ban recurring.

However, while the ban may address the problem of the stock of black money in cash, the question is: Will it encourage people to disclose all income and start paying taxes on it? Or does that require simplification and rationalisation of the tax system? As long as agricultural income can be used as a route to avoid taxes and indirect tax rates have multiple rates and exemptions, the problem of tax evasion is unlikely to go away.

On the negative side, the disruption in transactions could hit the emerging growth of consumer demand. In 1978, India denotified the 1,000 rupee note, and nothing much happened. A black market sprang up, people who had these notes took a loss while selling off these notes to people who could claim these as legitimate income. At the time, those notes were 0.6 per cent of the cash in circulation. Things are more daunting this time as 85 per cent of the cash in circulation is in the old Rs 500 and Rs1,000 notes.

A monetary economics perspective is useful. In India, there is one concept of money supply for the formal economy (the total money in all banks) and another concept of money supply for the informal economy (the cash in circulation). We will have an 85 per cent reduction in money supply for the informal economy for some days. Money is the means of transacting in the informal economy - payments will be held up and purchases will be postponed.

Some see this move as a way of pushing the country forward towards a cashless economy. There are two problems with this perspective. First, it is not that high denomination currency notes will go away. The existing notes will be replaced by new notes. Second, the cashless ecosystem is not ready to support a whole range of new users; this push is premature. Those who move from the denotification of the Rs 500/1,000 notes will not take to electronic payments. Their quest could instead take them to new notes, gold, US dollars and the bitcoin.