Monday, 7 April 2014

No escape from freedom

Indian Express, 3rd March 2014

A closed capital account is not a real option. We should focus on sequence and timing.

In his article, 'Against the flows' (IE, February 24), Gulzar Natarajan said capital controls were good and necessary. Liberalising our capital account, he claimed, will not benefit India either through higher growth or investment. It will only result in currency crises and higher risks, which we cannot manage.

India must, therefore, not liberalise its capital account - even the IMF has endorsed this line of reasoning according to Natarajan. But this argument ignores India's de facto capital account openness, the aspirations of a young and ambitious country, which does not want to go back in time, and the enormous body of evidence on the failure of capital controls as a tool of macroeconomic policy.

Economists like to think that there is a debate about capital account openness and that a decision about whether it should be open or closed is yet to be made. But this is not what happens in the real world. In the real world, a maturing country develops a capable financial system and sophisticated firms. It develops a liberal democracy, where the government is unable to interfere in the freedom of citizens. Once a country reaches this state of maturity, the capital account is de facto open.

Whether some economists think it should be open or not, in the eyes of the top 10 per cent of India - which makes decisions for the bulk of the economy - the capital account is open. To close it requires intruding on personal freedoms, inflicting harm on internationalised firms, and damaging the financial system.

When some Indian bureaucrats have argued in favour of a closed capital account at international forums, they have faced amusement from the audience. No country has taken this idea seriously. This so-called "lesson from the global financial crisis" is something no one is interested in learning. There has been no reduction in capital account openness - either among advanced countries or among emerging markets - after the crisis. The free movement of goods, services, ideas, capital and enterprise across national borders is an integral part of modernity.

Capital controls in emerging economies, where they exist, are like tariff or non-tariff barriers that can be switched on and off. They can be price- or quantity-based. Most evidence shows that these controls have little usefulness, both in terms of the time period for which they are actually effective, and in terms of their macroeconomic impact, which is limited and short-lived.

Advocates of capital controls have argued that their failure to deliver results is because they have been temporary. It is contended that permanent controls, which intrude deeply in the functioning of the economy, would work better. India is a rare laboratory that permits restrictions on capital flows.

The present Indian framework is a complex licence-permit raj. It is unlike what is found almost anywhere else in the world. We, in India, know that complex licence-permit systems always work badly, and are almost allergic to the thousands of pages of detailed restrictions.

Have Indian capital controls been effective? The effectiveness of controls is an often-misunderstood concept. We should measure whether they were able to achieve the objective that they were imposed for. If the all-in-cost ceiling for external commercial borrowings (ECB) was reduced from Libor plus 400 basis points to Libor plus 200 basis points, then the question to be asked is not whether borrowing went down. Instead, it should be whether this decision was able to achieve the objective of the restriction - for example, to reduce net inflows. All too often, companies respond to controls by simply changing the garb in which the same capital flows.

If companies moved from pure debt under ECB to foreign currency convertible bonds, the same money would come into India under a different name. One could then wrongly argue that the controls were effective because flows under ECB declined after restrictions were imposed. But the original objective - reducing overall inflows - was not met. Careful analyses of effectiveness have demonstrated that the Indian framework has not delivered on the objectives of macroeconomic policy.

Natarajan's article is about the least interesting end of the capital account openness puzzle. There are two interesting questions to be asked. First, in what order and sequence should controls be removed? Second, what auxiliary actions should India undertake in order to become resilient to the new challenges that an open capital account introduces? If you have air travel, you will have plane crashes, and the country will need to develop the institutional capability to respond to crises. It is interesting and important to understand the regulatory framework required for aircraft and airports. But surely, nobody would propose that we should not have planes.

This takes us to the territory of technical questions that generally do not fit neatly in opinion pieces. What does prudent foreign borrowing mean? Should rupee-denominated debt continue to be more restricted than foreign currency-denominated debt? How can companies be encouraged to hedge their currency risk? How can we help markets for hedging develop? And so on. These are the interesting questions in the field of capital controls - not ideological sloganeering about whether capital account liberalisation is good or bad.

To a significant extent, this is about generational change. One generation ago, it was interesting and fashionable to discuss whether India should liberalise its capital account or not. Things have changed. We are now a $2 trillion economy, with capable global firms, with aspirations for a sophisticated financial system, with a liberal democracy that makes it infeasible for the government to arbitrarily restrict the freedoms of citizens. In such a country, what merits attention is the sequence and timing of capital account liberalisation, and the establishment of institutional capability for fiscal, financial and monetary policy.

Hold on to interest rates

Financial Express, 1st April 2014

The impact of tighter fiscal and monetary policy on inflation is now visible in the recent price data. Inflation, measured both by the wholesale price index and by the consumer price index, has come down. It may still be too early to cut rates, but RBI Governor Raghuram Rajan can now afford to hold rates unchanged in today's monetary policy announcement. His strategy of an aggressive attack on inflation, despite the scepticism often voiced in the Indian monetary policy debate about the effectiveness of monetary policy, was the right strategy and is yielding results.

Considering that inflationary expectations in India are high and persistent, and could take a while to come down, Rajan should not cut the repo rate as yet. If the WPI inflation measure is the target, there is a case for cutting rates since this has come down sharply. However, the CPI, the target towards which the RBI sensibly appears to be moving, is still above 8% and there is fear that it may go up due to unseasonal rains. Also, CPI based inflation has not remained low long enough for inflationary expectations to fall.

The fiscal and monetary contraction of the last 9 months, as well as the slowdown in the economy, have contributed to the reduction in inflation. In this environment, effective communication by RBI that its focus will be on inflation control, has played an important role. In addition, the setting up of the Urjit Patel committee and its view that RBI should adopt inflation targeting has helped counter some of the traditional RBI view that monetary policy has no impact on inflation, that India has a weak monetary policy transmission mechanism so there is no point in trying to raise rates, that inflation in India cannot be measured properly and so on.

The war on inflation is still not won. The present dip in inflation must be sustained for many months before RBI can relax. Despite the fall in GDP growth, the consequent slowdown in demand, and the fall in commodity prices, Indian inflation is higher than what is seen elsewhere in the world. Inflation in food has contributed most, but inflation in non-food has also been sticky.

Looking forward, there is a contradiction between RBI's aggressive stance on inflation and its intervention in the foreign exchange market. RBI's stance on monetary policy could be undermined by its intervention in the foreign exchange market. In recent weeks, RBI appears to be intervening in the foreign exchange market to prevent the rupee from appreciating. The extent of intervention and its sterilisation is not known yet. If the intervention is unsterilised, then it would lead to an increase in liquidity and would pull down interest rates even without a monetary policy announcement. Indeed since RBI's monetary policy is not conducted only through the interest rate instrument, but also through its intervention and sterilisation, something that the Governor does not announce with the policy stance, it has been seen in the past that while actions on the policy rate move in one direction, the liquidity conditions in the market can move in quite the opposite direction. This was the story of the mid-2000s, when RBI was intervening in the foreign exchange market to combat rupee appreciation and raising the repo rate at the same time to fight inflation. Its intervention was only partly sterilised and was pumping liquidity into the system pushing up inflation. As a consequence, the policy rate hikes were ineffective.

Inflation targeting countries usually solve this problem by adopting a flexible exchange rate. In other words, the exchange rate is allowed to move, while inflation is stabilised. Sometimes there may be occasional sterilised intervention by the central bank. However, central banks that target inflation do not pursue pegged exchange rates for long periods. This means that they do not require resources for sustained sterilisation. While the Urjit Patel committee has proposed that RBI target inflation, it has also proposed that the central bank should get unlimited sterilisation powers. Occasional foreign exchange intervention and sterilisation to contain volatility do not require unlimited sterilisation capacity. If RBI is move to an inflation targeting framework, it cannot plan to do unlimited sterilisation. The People's Bank of China, the Chinese central bank, which targets the exchange rate, has such powers. Other central banks do not have such powers as these are inconsistent with the mandate of inflation targeting. In other words, if RBI is to seriously adopt inflation targeting, it must give up on pegging the exchange rate. Trying to target inflation and exchange rate simultaneously on a sustained basis is inconsistent.

A further consideration in the decision about the stance of monetary policy would be global liquidity considerations. Janet Yellen's recent comments suggest that the US Fed could start raising rates next year. As long as the US monetary policy remains unconventional, i.e., until the time comes when the FOMC discusses and decides policy interest rates rather than the purchase of bonds, it remains in uncharted territory. Low inflation, along with a low current account and fiscal deficit, would be a more prudent policy, as there could be sharp and sudden changes in US and global liquidity conditions. This may prompt RBI to keep interest rates unchanged.

Open up the capital account

Financial Express, 15th March 2014

India's path to capital account convertibility will be an important question for the new government. Left thinkers have attacked financial globalisation, pointing to the risks it brings to emerging economies, especially after the financial crisis. For the new India with world class multinationals, with a skilled labour force and the potential for becoming an international financial centre, the Left arguments perpetuate backwardness. The next government needs to move forward with rationalisation, liberalisation, removal of bureaucratic overhead, and establishing the rule of law so that Indian companies and citizens have greater freedom to manage their finances and access to world-class products and lowest prices. Missteps on this process will generate shocks to the exchange rate and to the economy.

India has a large and complex system of permanent and pervasive capital controls. Numerous agencies have been given powers to interfere with cross-border transactions. It is often not clear why certain controls are in place. For India to succeed, the relevant question is: How to open up sensibly?

The first element for policy is the hygiene of good governance. The principles of transparency, accountability and rule of law, which have gained prominence across all parts of the working of the state, are equally relevant here. Across the landscape, there is unhappiness about the bureaucratic overhead faced in doing simple things-it is time to slash the red tape and simplify procedures. This is just the hygiene of sound public administration. The government is in the process of voluntarily implementing the governance-enhancing features of the Indian Financial Code that was drafted by Financial Sector Legislative Reforms Commission (FSLRC). These will yield major gains when applied to the working of capital controls.

Percy Mistry, whose report argued for making Mumbai an international financial centre, has long reminded us that there are no accidents on a village road not because the traffic police is effective, but because there is no traffic. Whether we should have financial globalisation is no longer a question for India. The question now is: How can we open up to the world and, at the same time, undertake measures to become strong and

resilient? For example, steps to increase the liquidity of derivatives markets, removing caps on rupee-denominated debt and enabling firms to hedge their foreign currency exposure will make the economy more

resilient. Engagement with the world introduces new risks-and the best way to deal with those risks is to have deep and liquid markets as shock absorbers. So far, RBI has prevented the emergence of a deep and liquid market for the exchange rate and for bonds. This needs to be reversed.

In the minds of some policy makers, there is the idea that capital controls can be switched off and on at will, based on the movement of the exchange rate that is desired. This idea is flawed at numerous levels.

First, the existing evidence shows that these attempts at tinkering with capital controls do not yield the desired impact on the exchange rate. The hoped-for outcome is not realised.

Second, there are important costs. To make an analogy, consider the export of onions. If India repeatedly switches off and on the export of onions, this frustrates the development of sophisticated firms with long-range contracts and a deep understanding of the international onion trade. In fact, the very possibility that a government might shut off a business hinders firms from investing in developing those capabilities. If the government threatened that they would shut down barber shops in the future at whim, there would be fewer and inferior barber shops.

Participation in the global onion trade requires complex firms with a rich network of human networks and long-term contracts. So it is with international financial activity. For Indian firms to grow roots in global finance, and for global firms to grow roots in India, both sides have to invest considerable amounts in the long-term objective of building organisational capability. When India indulges in a ban, this kills off organisational capability. When India even threatens to impose a ban in the future, investments in building this capability are reduced.

The defining problem in a safe and sound engagement with financial globalisation is that of overcoming asymmetric information. When the global financial system does not have a deep understanding of India, it is more likely to make mistakes, with capital surges, sudden stops, mistakes in investment flows, knee-jerk responses to events, etc. To avoid these maladies, we require that global financial firms have a deep knowledge of India. This deep knowledge is impounded in the organisational capital of global financial firms: in their staff, in their processes, in their long-term investments in learning India. But for this to happen, we have to stop banning cross-border activity and change laws so that there is no possibility of bans in the future.

To simplify the complex system we have, we need to ask what is the objective of each and every control in place and to undertake the task of steadily dismantling unnecessary restrictions. Some controls were put in place to prevent capital from flowing in and while others were imposed to prevent capital from flowing out. These channels of flows get circumvented by investors and overall inflows and outflow occur based on economic conditions, but the restrictions create distortions. The task is challenging, but necessary for India to become globally competitive.

With an eye on inflation

Indian Express, 14th February 2014

Flexible inflation targeting is the best way to dent price rise.

India is the only large emerging market (EM) that doesn't currently have a monetary policy framework. Other than China, which targets the exchange rate, all large EMs target inflation. This is one of the main reasons why India saw a rise in inflation after the global financial crisis, while other EMs experienced a downward pressure on prices. It is clear to students of monetary economics that an inflation-targeting framework is the way forward for India, which is opening up its capital account and moving towards a flexible exchange rate regime.

India has chosen these two corners of the trinity - and this allows it to have an independent monetary policy. The lack of a monetary policy framework is a recipe for high inflation, low growth and highly volatile business cycles. The Urjit Patel report to revise and strengthen the monetary policy framework has recommended that the RBI adopt flexible inflation targeting.

What are the main elements of inflation targeting? First, a monetary policy framework requires a defined nominal anchor. There are many factors that determine the relative price of any two goods, while the nominal anchor determines the general level of prices. So, for example, if there are only two goods in an economy, and one costs double the other, what determines whether the prices are Rs 10 and 20 or Rs 100 and 200? When economies started using paper money, it became possible to create an unlimited amount of money. But this could cause these prices to rise to Rs 1,000 and 2,000 or any other such combination.

When paper money was anchored to gold or silver, or, in some cases, to the sterling or dollar, this used to determine the general level of prices. However, when these systems ran into trouble, countries chose a general price level as the anchor, with some allowance for changes in relative prices. A small amount of growth in the general price level allows for smooth changes in relative prices. Thus, the price level and a small, specified increase in it became the nominal anchor. This was the inflation target.

Such an anchor incentivises households to save. It allows businesses to plan, knowing how their cost structure will evolve over the years. After 1990, inflation targeting was adopted by 34 countries. The OECD countries were among the first to adopt it and, after 2000, a number of emerging economies such as Brazil, Chile, Colombia, South Africa, Thailand, South Korea, Mexico, Peru, the Philippines, Indonesia, Turkey and many east European countries followed suit.

More recently, after the global financial crisis, even developing countries started adopting this framework. After 2008, we have seen countries like Georgia, Moldova, Albania, Botswana and, in 2011, Uganda adopt inflation targeting. The fruits of the framework have been enjoyed by emerging economies. While all EMs are suffering from a slowdown in demand, India is suffering from stagflation. None of the other large EMs is experiencing such high inflation. None of them has such unanchored inflationary expectations.

Some people suggest that GDP growth should serve as the nominal anchor. But this is not possible. If it were, several countries would have already targeted growth and become rich. Countries with the highest inflation, like Zimbabwe, would also have been the fastest growing ones. An inflation-targeting framework takes into account the effect of various demand and supply shocks on inflation, output and exchange rates, and accordingly forecasts inflation, which the central bank then tries to bring back to the target rate in the medium run. For those interested in the details, Rudrani Bhattacharya and I have a recent paper on how an inflation-targeting framework would work in India.

The paper presents a typical forecasting and policy analysis model, which shows how an inflation-targeting framework takes into account various cyclical factors that impact aggregate demand and supply to forecast inflation. One of the main problems with the public discourse on inflation targeting is that it assumes inflation-targeting central banks only look at past inflation and adjust rates accordingly, rather than figuring out how demand, supply and expectations impact inflation. As the Urjit Patel report argues, while there is a tradeoff between inflation and growth in the short run, there is no tradeoff in the medium run, and cross-country evidence suggests that low and stable inflation is, in fact, better for growth. No country has given up on an inflation forecast in its monetary policy framework.

The proposed flexible inflation-targeting framework also takes into account the difficulties India faces due to high and volatile food prices. In other emerging economies also, food accounts for a high proportion of the consumption basket. The report argues for the consumer price index, of which food is a large component, to be used as the measure of the nominal anchor. A CPI inflation target of 4 per cent, which can be breached by 2 percentage points on either side, will allow the RBI not to respond if inflation is above 4 per cent but within the target band, as long as this is because of supply shocks that will not persist. With the inclusion of food inflation in the target, its spillover into non-food inflation will reduce, keeping overall CPI inflation in check even if there are spikes in food inflation.

However, it should be elected representatives, and not unelected central bankers, who decide what the nominal anchor and monetary policy framework should be. Once decided, the central bank should be given the power to pursue these objectives and it should be made accountable to the democratic representatives of the people. Eventually, in India too, as in most other countries, the monetary policy framework must be enshrined in law. This was also the opinion of the Financial Sector Legislative Reforms Commission. In the meanwhile, the proposed framework is a huge step forward. It is in accordance with the voluntary adoption of governance-enhancing principles that regulators are embracing till the Indian Financial Code is legislated upon.

Wednesday, 22 January 2014

Not by babanomics

Indian Express, 22nd January 2014

Tax reform is a serious issue. Transaction tax is a bad idea.

In a recent speech, Narendra Modi said that India needs tax reform. The BJP is reportedly evaluating various reform proposals to include in its manifesto. It is important to evaluate these on the basis of both economic theory and international experience.

The most prominent proposal on tax reform is the one supported by Baba Ramdev. He has proposed a tax on all bank transactions. According to the proposal, such a tax will eliminate "black money". Money is considered "black" only when the payment of taxes has been evaded. Under a transaction tax regime, evasion is technologically impossible because the bank will be responsible for the collection and payment of taxes, which will take place electronically. Such a tax is supposed to be simple - with little cost of collection, no filing of tax returns and no possibility for evasion.

By implementing this proposal, it is argued that India can get rid of all the complicated taxes it has at present. There will, however, be no taxation of cash transactions because it will be difficult to implement. To ensure that people do not start transacting in cash alone, it is proposed that Rs 500 and Rs 1000 currency notes should be demonetised.

Why is this not a good idea? Transaction taxes are often referred to as "sand in the wheels". They are meant to discourage certain kinds of transactions. The original "Tobin tax" on currency market transactions was intended to reduce the magnitude of currency trading turnover. Those who argue for transaction taxes do so on the grounds that they will reduce transactions. In other words, it is well understood that when the government starts taxing certain kinds of transactions, people move away from them towards other kinds of transactions. If one method of making payments involves being taxed, people will choose other methods.

Transactions on the street will shift to dollars, gold, bitcoins and other unexpected things. For example, bottles of Tide detergent are reportedly popular as a currency in underworld transactions in the US because they are untraceable. Cigarettes can be used for small transactions. A one cubic centimetre piece of gold weighs 19.1 grams and is worth approximately Rs 56,350. These could be used for larger transactions. This would result in the further decline of the Indian rupee as a trusted vehicle for the storage and transportation of value.

Commentators have highlighted that the international experience of transaction taxes shows that they do not support revenue collection of more than 2 per cent of the GDP, and even this declines over time. Most countries have given up on transaction taxes. Such taxes do not yield the 10 per cent of GDP that even a minimal government, such as the one that Modi is said to want to oversee, will need as revenue.

But lest it be thought that this tax is only dysfunctional in foreign lands, let's take the example of an Indian transaction tax - the stamp duty. If property is bought or sold, a set percentage of the value of the transaction is supposed to be paid as tax. Only if the transaction takes place through the banking system is it recorded, necessitating the payment of the stamp duty. So what do people do? They transact partly in cash. This part of the transaction is unrecorded and therefore the tax on it is not paid. Of course, this is illegal - the amount that is declared as the value of the transaction for the property is less than what it actually is and duty is being evaded. Does the inconvenience of counting, transporting and paying in notes of, say, Rs 500 prevent this cash transaction from taking place? No, it does not. In fact, in the real estate sector, it is difficult not to transact in cash. Tax evasion has become the norm. This has numerous downstream consequences - a network of illegality in real estate, weakness of the property tax, etc. Public finance experts believe that stamp duty should be eliminated to reduce black money in real estate.

Rather than encourage compliance, the stamp duty incentivises people to move away from the formal economy. With the proposed banking transaction tax (BTT), this is likely to become the norm for the bulk of the economy as there will be a "stamp duty" on all transactions routed through the banking system.

The dream of getting rid of myriad tax collectors is a good one - but it requires a great deal of action at the level of state governments, which have their own tax administrations. A constitutional amendment is needed to take away the taxation powers of states. The negotiations of the empowered group of state finance ministers regarding the GST - one of the few truly good ideas in tax policy in India - have been a long saga over the 2004-13 period. How will all state governments ever be persuaded to abolish their taxes in return for a slice of the BTT?

No country in the world has eliminated all taxes and replaced them with a BTT. If a government wishes to reform India's tax system and reduce evasion, there are better ways to do this and simplify the system. The right strategy combines a flat low rate of income tax on individuals with an EET (exempt-exempt-taxed) treatment of savings, a removal of myriad exemptions, a clean and simple GST and the removal of most existing taxes so that we end up with exactly two taxes - an income tax on individuals and a GST on firms. Many expert tax and public finance committees have recommended this based not just on rigorous economic theory, but also on international evidence. Tax reform is an important and serious issue and can have a huge impact on economic conditions in India.

Tuesday, 14 January 2014

Same old banking

Indian Express, 14nd January 2014

The RBI's mandate-driven approach has constricted financial inclusion

A Reserve Bank of India panel has submitted a report on financial inclusion. It proposes that priority sector lending by banks be raised and that banks be mandated to open accounts for every adult Indian by January 2016. The recommendations do not challenge the RBI's basic approach to financial inclusion. This approach, which has been to mandate banks to undertake financial inclusion, might have spread public sector bank branches in rural areas for some years, helped open bank accounts and directed credit, but it has stopped yielding results. What India needs is a new approach, which encourages competition and innovation, rather than more mandates.

India's approach to financial inclusion has been bank-centric. So far, it has focused on bank nationalisation, continued with government ownership of banks and their recapitalisation. The way to ensure inclusion has been priority sector lending, which mandates that 40 per cent of each bank's lending be to weaker sectors - small-scale industries, agriculture and exports - to which the bank might not have lent otherwise. The RBI panel now recommends raising this share to 50 per cent.

The panel's recommendations are in sync with the RBI's recent guidelines for the grant of licences to new banks. These require that the bank have a plan for financial inclusion and that it open 25 per cent of its branches in unbanked rural areas. This approach is similar to the one that required PSU banks to open rural branches. By once again mandating financial inclusion, this time for private sector licence applications, instead of focusing on competition and innovation, the RBI is essentially doing more of the same.

Financial inclusion may be defined as access to a range of financial services in a convenient, flexible, reliable and continuous manner from formal, regulated financial institutions. Even though access can be ensured by mandates, the quality parameters of access may be compromised in the process. This is seen in the low usage of accounts and the poor asset quality of priority sector portfolios. Such inclusion confuses ends with means. A bank account is meant to fulfil certain functions - simply opening an account is not enough. The panel proposes to make it mandatory for every Indian over the age of 18 to have a bank account.

An often overlooked consequence of the mandate-driven approach to inclusion, as pursued by the RBI, is that the costs of this inclusion are levied on the investors and consumers of banks. The losses from unused bank accounts and poorly performing priority sector assets are eventually borne by the investors and consumers. If the political objective of opening bank accounts is to be met, or lending to certain sectors ensured, it should be transparent as a line item on the government's budget. Instead, it is done through a cross-subsidy that effectively makes other customers pay for the political goals of a government pushing its agenda through banks.

This approach has been accompanied by a neglect of the other drivers of inclusion - competition and innovation. In the last 11 years, the Indian economy has grown rapidly, but no banking licences have been given in this time. The trend has been that once a decade, the RBI decides to give a few licences, but there is no window to get licences during this period. The incumbent banks feel little or no pressure to reach out to unbanked areas and people with their services. This, in turn, necessitates a mandate-driven approach to financial inclusion. Despite decades of RBI mandates, rural customers turn to informal channels and unregulated financial firms.

As part of the RBI's bank-centric approach, there are regulatory and entry barriers to prevent bank-like institutional mechanisms from competing with banks. For example, money market mutual funds, a viable alternative to bank deposits and popular in countries such as the US, are not allowed to issue cheques by the RBI, which also regulates the payments system. This reduces competition to banking. These barriers help generate complacency among banks and curb the extent to which new business models emerge.

The mandate-driven approach to financial inclusion has also been a key hindrance to innovation. The RBI has emphasised specific quantitative targets, such as priority sector lending or opening bank accounts. Lately, appointing customer service providers has been added. A consequence of these mandates is that the rural business departments of banks are too busy trying to meet the targets to spend time and effort in actual innovation that serves the consumers.

A comprehensive change in regulatory philosophy is required to bring about meaningful financial inclusion in India. This would entail a shift from the present bank-centric, mandate-driven approach to an emphasis on competition, innovation and consumer protection as the pillars of regulatory philosophy. The Financial Sector Legislative Reforms Commission has recommended an approach to financial regulation that is based on these three pillars.

To encourage competition, the RBI should not decide the optimal number of banks for the country. Bank licences should be available on tap, based on reasonable eligibility criteria. The RBI should also permit the emergence of new business models in banking, non-bank lending and payments. An increase in competition should encourage existing banks and newcomers to explore opportunities beyond the markets that have already been served.

The second pillar is allowing innovation to happen. The RBI's present approach prohibits innovation until it is expressly permitted. This approach has led to delayed innovation across all products and processes. For example, the business correspondent model, which enables the delivery of banking services through low cost agents, was introduced more than a decade after it made headway in comparable emerging markets. The RBI must shift to an approach that allows innovation to happen and then responds with proportionate regulations.

Increased competition and innovation must be accompanied by consumer protection, acknowledging the imperfections in financial markets. The idea of financial inclusion must not be limited to getting access. This access must help consumers use finance in beneficial ways, with the regulator protecting them from unfair contracts and terms.

Consumer protection also translates into proportionate regulation to maintain the safety and soundness of financial service providers. A bank or an insurance company must be managed prudently enough to minimise the probability of failure. The failure probability need not be zero, for that would lead to excessive conservatism. Once in a while, when a financial firm fails, it should be resolved in a manner that entails the least pain for the consumers.

India needs a new approach to financial innovation and it is time the RBI realised that more of its mandate-driven approach is not the solution.

Saturday, 11 January 2014

Regulator, not planner

Financial Express, 11th January 2014

The UPA's political agenda of inclusive growth through rights and entitlements is now being carried forward by the banking regulator, RBI, which has taken upon itself to give India growth with a human face. The central bank will now seek to become the central planner. The committee on comprehensive financial services for small businesses and low income households, headed by Nachiket Mor, has created a utopian vision of a world where rights and entitlements go even beyond what the National Advisory Committee came up with, to extend to a right to bank accounts and other financial services.

The panel's report lays out a vision that is so precise and detailed that it reeks of central planning. The report has a vision statement around each type of financial service. Coverage targets are given along with dates and timelines extending to the next few years. For example, the panel says every Indian resident above the age of 18 should have a bank account by January 1, 2016. The credit-to-GDP ratio in every district of India is envisaged to grow to 10% by January 01, 2016, then growth at 10% per annum and reach 50% by January 02, 2020. The report says that by January 10, 2016, each district would have a total deposits-and-investments-to-GDP ratio of at least 15%. This ratio would increase every year by 12.5% with the goal that it reaches 65% by January 1, 2020.

Not suprisingly, the panel recommends that RBI issue a circular indicating that no bank can refuse to open an account for a customer who has adequate KYC, which specifically includes Aadhaar. A bank would not have the choice to refuse opening accounts, even if its business model does not permit it to do so. The panel does not say what this inclusion will cost the system. Neither does it say who will pay this additional cost. Will it be the government whose political objectives it seeks to meet, or will it be other customers, the borrowers who will pay higher interest costs and the depositors who will receive less interest? Is it in the interest of bank customers to have these costs imposed on them, or, it is it cross-subsidisation without a political mandate?

The costs imposed are effectively taxes. The opening of accounts and other intrusive, distortionary recommendations flow directly from the utopian vision. In most markets, and especially in financial markets, central planning distorts the incentives in a manner that does more harm than good. It is not RBI's job to pursue this political agenda. The panel has confused RBI's role in the financial system. It seems to have assumed that RBI is not a regulator, but the owner and planner of the entire system. It also seems to have assumed that RBI has some God-given mandate to ensure redistribution from some consumers to some other consumers.

The forum for redistribution is Parliament, which is the place where competing welfare objectives are assessed. If the committee indeed believes that right to banking is such a fundamental right, it should have drafted a 'Right to Banking Bill' and submitted it to the government, with a recommendation to place it in Parliament. Parliament will approve expenditures to pay for the right to food. It needs to do the same with the right to banking. The report builds upon RBI's approach to the financial sector so far. RBI has tried to achieve greater financial inclusion, but with little real success. Priority sector lending targets have existed for decades. In the recent years, RBI has come up with more mandates for banks to open bank accounts, which remain largely unused. RBI has done central planning and redistribution. This report doubles up on that approach.

The panel has made the classic central planner's mistake of confusing ends with means. The kind of vision it has enunciated might lead to access in name only, but little functional consequences for the consumers. This is how the government has done things in India for a long time, and it has not worked. The government sets a simplistic goal, even in markets for complex services, and then goes on to centrally plan the process that will lead to the goal. The root of the problem in setting such goals, which inevitably lead to the logical next step: central planning. This is fundamentally different from saying that the government (in this case, the regulator) will fix the problems that might be preventing the market from achieving the desirable outcomes.

The same problematic vision is reflected in the report's treatment of different stylised business models of banking. It outlines certain business models, and then goes on to identify what each can do for financial inclusion. There is nothing wrong in such analysis as long as it is an academic exercise. In the hands of a central planning regulator, this thinking can be a recipe for disaster. It is impossible to foresee what the different business models might achieve. Placing them in cubbyholes, which lead to further restrictions is a bad idea. It would have been much better had the committee recommended that RBI open its doors to different business models, and impose risk-based regulations on each.

There is a strong focus on attaining financial inclusion through extending the reach of banking networks. This 'bank-led' crusade of RBI clearly stems from a gross misunderstanding of the demand-side requirements of financial inclusion and access. India is a heterogeneous country with large variations in people's preferences. Instead of evaluating the efficacy and failures of past financial inclusion efforts, which have also centered on banks, the panel assumes having more banks and more savings accounts will lead to better outcomes.

The panel is not satisfied with merely using banks for purposes of savings and resource mobilisation; it goes a step further and recommends creation of 'payments banks' within banks which enables bundling of 'universal payment services' with 'universal bank accounts'. Global experience, be it from the United States or Kenya, suggests that banks based on legacy systems are both inefficient and unconcerned about delivering low-value payments services to their customers as it does not make much business sense for them. Our own experience with the still-birth and the lack of transactions on the bank account dependent Immediate Payments Service (IMPS) started by the National Payments Corporation of India (NPCI) seems counter-intuitive to the 'payments bank' suggestion made by the report.

In summary, inclusion is a political agenda and the job of the banking regulator is not that of a political authority, but of a regulator that protects consumers and focuses on the safety and soundness of the banking system.

Thursday, 2 January 2014

Constricted by law

Indian Express, 2nd January 2014

APMC acts impair the freedoms of farmers and consumers.

Rahul Gandhi has announced that fruit and vegetables will be removed from the list of commodities under the agricultural produce marketing committee (APMC) acts in Congress-ruled states. This is an important move towards the freeing-up of markets, and will bring in competition and remove barriers to entry. It is expected that the de-listing will reduce the prices of fruit and vegetables in the long run and encourage investment in cold-storage facilities and warehouses. If the government wishes to reform agriculture and control food inflation, the reform should not stop here.

APMC acts were passed by states during our socialist past. They restrict whom farmers can sell to, who can get a licence to buy produce, and where trading can take place. This has given rise to a system with substantial barriers to entry in the trade of agricultural products. The freedom of farmers and other citizens to buy or sell as they like has been abrogated - farmers are forced to sell to traders who hold APMC licences at APMC prices.

As with many other state structures in socialist India, APMC regimes rapidly turned into rackets. Hardly 30 per cent of the mandated "open auctions" are actually open or transparent. New licences are mostly given to persons who already have shops and godowns in the prescribed market area. Shops in these areas are limited and are mostly available only to friends and relatives of existing traders. There are no transparent criteria for sale or for getting a licence. There is no time-bound application processing period during which a licence is either granted or refused. A licence is granted for a period of one to five years. Thus, the incentive for long-term investment is diminished. Regulatory capture by local trading communities is said to be the norm. These traders control the entire marketing chain, including credit, inputs, storage etc. Prices are often bundled, and there is a lack of clarity on what the exact price of the produce is, and what the interest on the credit and other items is.

These traders then sell the fruit and vegetables to wholesalers who are also APMC-licenced traders and set prices in the wholesale market. Pricing is a mark-up over costs. Various studies have identified this monopsonistic-monopolistic market structure and the lack of free entry and competition as the reason for large middleman margins. For some products, the farmer gets only 40 per cent of the price paid by the end consumer. This market structure does not permit the entry of new players who want to set up cold chains and invest in other infrastructure, keeping marketing costs high. Sometimes, the marketing cost is itself nearly a fifth of the total price paid by the consumer.

The government's approach to reform has been to try to change the APMC acts. In 2003, the Central government circulated a model APMC act and asked the states to adopt it. Sixteen states changed their acts accordingly, though only six notified the new rules under their act. The model APMC act does not solve the problem. Though it allows contract farming, it does not free up entry and exit into trading. It does not allow different business models to spring up. Some states allegedly adopted a few elements of the new act because there was a fiscal incentive to do so. The one state to strike a happy note in this bleak landscape is Bihar, which repealed its APMC act in 2006.

While the structure of this market is badly designed, it has not changed over the last decade. Then why has food inflation surged? Part of the answer lies in the change in consumption. The demand for non-cereals - particularly protein, fruits and vegetables - has increased with the increase in household incomes. When income rises, households do not just eat more rice and wheat. They graduate to a better diet and nutrition. Part of the answer also lies in the higher labour costs of production. The labour intensity of the production of non-cereals is higher than that of cereals. Estimates suggest that while it typically takes 55 man-days per hectare for the production of wheat, it takes 124 for onion, 110 for cabbage and 195 for tomatoes. Wage costs have also been rising since 2008.

While the increase in the prices of cereals because of the rise in minimum support prices has got a lot of media attention, the increase in the prices of fruit and vegetables has been relatively neglected. It's sometimes assumed that the supply has not responded to the rising demand. However, an examination of the data reveals that the production of non-cereals like eggs, meat, fish, fruit and vegetables has risen quite rapidly. It is not as if the market economy has not responded. The question is: at what price is the new production willing to come in?

The combination of high costs, a market structure with mark-up prices and the lack of suitable storage facilities has given rise to high and volatile prices. This is why removing these food items from the purview of the APMCs becomes important. This will foster entry, investment and competition in this key weak-link of Indian agriculture: the processes from the farm to the fork.

While it is good that fruit and vegetables will be removed from APMC lists, there is no reason to keep other agricultural items on them. For example, why should the freedom of the producers and consumers of dal be impaired? This calls the entire edifice of the APMCs into question. Why should all Congress-ruled states not match Bihar's modernisation by repealing their APMC acts?

Another element of the five-point programme announced by Gandhi is the use of the Essential Commodities Act (ECA) to attack hoarders. This flies against what is being attempted by bringing private players into the fruit and vegetable markets. The ECA does not permit private traders to hold food above certain quantities or for more than a certain number of days. The state usually does not have storage capacity. If private traders are allowed into trading and storage, food price volatility could decrease. The ECA has often been used arbitrarily to impose restrictions on the trade and holding of food. What we require is economic freedom and a competitive market. This will yield higher productivity in agriculture and lower prices for consumers, and requires getting rid of the APMC acts and the ECA.