Sunday, November 27, 2016

Demonetisation - disabling the ability to say "I dont know"?

The raging debate around demonetisation has an interesting relief - the inability of the commentariat (bankers, media, economists, astrologers, bhakts - in no particular order or mutually exclusive category) to say, "I dont know". We have had revised GDP forecasts (an investment bank predicted a 3% hit, based on a bizarre conflation of high powered money and broad money. Ex-PM Manmohan Singh predicted a 2% hit, basis, well nothing that he cared to elaborate). We have also had pop sociology in full flow, with assorted bhakts claiming this is a "revolution" of society and economy together - recently departed Castro would approve!

Issue though is, economically, demonetisation in this scale (and economic stage) is so unprecedented that its difficult to see how any of these numbers are even ca lculated, forget being credible. As Niranjan Rajadhyaksha described in his column, demonetisation is a natural experiment, albeit one on a very large scale and hence inherently risky. What are the issues in this case in deriving assumptions on economic outcomes? Lets see it at a basic level.

The essential monetarist view of GDP is explained by the following equation:

M X V = P X Q, where
M: Money supply in the economy (the total amount of currency notes and bank deposits circulating in the economy)
V: Velocity of Money (number of times a rupee of cash/deposit circulates in the economy per year)
P: Price levels in the economy
Q: Volume of Output in the economy

From a monetarist perspective, how inflation (P) and GDP (output, Q) behave is a function of the changes in M and V.

Now lets see what happens as a result of demonetisation to each of these variables.

Money supply (M) gets an upfront negative shock, as the RBI on 8th Nov withdrew ~14 lac crores of banknotes, accounting for ~12% of total M in the economy. This, taken on its own is a significant monetary contraction, and should result in interest rates shooting up (interest rate is the price of M, if supply of M goes down, price should go up). However, on the other hand, withdrawal of banknotes has been accompanied by a huge accretion of deposits as people have been asked to swap their banknotes for deposits in the bank. Now, a rupee in deposits adds a lot more to M than a rupee in banknotes (due to a concept called money multiplier). As a result, interest rates should decline (as M goes up with banknotes being replaced by deposits). Net net, we have two counteracting forces - one that is pulling M down, while the other is pushing M up. As of now, interest rates have actually come off drastically (and somewhat counter-intuitively), but how things will stabilise in the medium term - there isnt sufficient data yet to conclude.

Velocity of money (V) gets an upfront negative shock too, with cash being such an important medium of commercial transaction in the economy. Additionally, with new banknotes primarily coming in the form of the new 2000 rupee notes (that are difficult to "break"), V declines further, as the new notes are circulated less number of times than the same value of old notes could be. A reduction in V causes a decline in GDP (given all other things constant). However, a move, both forced and behavioral towards more cash-less modes of transaction (UPI/wallets/cards etc) tend to increase V, as electronic cash has greater V than physical cash. Increase in V accelerates GDP. There again, we have two counteracting trends emerging. Net net, how will this play out? We dont know (yet), too early to conclude in absence of data.

The most ubiquitous principle used by economists is that of ceteris paribus, or, all other things remaining constant. The ability to predict outcomes is dependent on the ability to fix the level of input variables. In the best of situations its an impossible condition to meet (a prime reason why astrology is often said to have better predictive powers than economics). In a massive real-time natural experiment of the sort we have in demonetisation, it is really besides the point to even consider.

In effect, the biggest point is, whether on interest rates, or inflation, or GDP growth - the impact is undetermined and as yet, undeterminable. The best answer that most folks could credibly have is "I dont know". But saying "I dont know" requires a level of humility missing entirely from our 24/7 commentariat.

Saturday, November 19, 2016

To be or not to be - RBI should directly recapitalise banks

The biggest kerfuffle going around on the demonetisation debate is on the use of currency that is expected to be "extinguished", ie, those old 500/1000 rupee notes that are never tendered back to the banking system. There is a general consensus that around 3-3.5 lac crores is the number.

The big question is whether this is money that is income for RBI that can be repatriated to the government as a special dividend, resulting in a fiscal bounty. Opinion is sharply divided on this. While there is a strong (financial market participant) view that it can be done, there are others like ex-governors D.Subbarao and C Rangarajan as well as perceptive columnists like Bloomberg's Andy Mukherjee (who wrote a strong column on the issue, though basis a seeming non-sequitur) who think otherwise.

In terms of  global precedent, the situation is equally murky. Previous instances in Germany and Israel (partly covered in this KPMG report) involved scales much smaller than what is being talked about here (3 lac crores would be just short of ~10% of RBI's balance sheet).

There's also the point on prudential accounting - typically large gains on balance sheet net worth arising out of revaluation isnt taken as "Income" in P&L (while losses usually are). And this effectively, is a gain arising out of revaluation of RBI's liabilities.

Is there a solution? Can the "money" be put to use? There is perhaps an answer, though it would raise a few hackles with purists. First, lets examine the RBI Balance Sheet (RBI annual report 2015-16)












As can be seen, the 2 biggest items on the Liability side are 1) notes issued and 2) Revaluation account. On the Asset side, the two biggest items are Foreign Currency Assets (FCA) and Domestic Investments (primarily G-secs held by RBI to facilitate Open Market Operations).

The Reval Accounts, comprising of a number of different accounts (Currency and Gold Reval Account-CGRA, Investment Reval Account-IRA etc) essentially capture Mark-to-Market (MTM) movements in the various Assets (and Liabilities) positions of RBI. Effectively, this reserve acts as the valuations buffer for RBI while carrying out market interventions (both foreign currency and domestic money market).

So, what happens if the total currency extinguished is (say) 3 lac crores? One, Notes issued goes down by the same amount. Two, the Reval a/c (RBI could create a special, different a/c to teat this) gets bumped up by the same amount. Note that the Reval a/c would now be ~30% of the size of RBI's balance sheet.

Now, given that a dividend cheque to the government is ruled out, what next? A simple exercise would be the  following:

1. Out of the ~7 lac crores of G-Sec holdings, RBI takes out (say) 2.5 lac crores and swaps it with a bunch of PSU banks for a special equity issuance.
2. Technically, it effectively means RBI sells 2.5 lac crores of G-Secs in the market to raise cash and uses it to buy equity in PSU Banks.
3. Normally, this could mean a fair amount of market impact. However, done as a straight swap with banks, and accounting for the very high level of liquidity available to banks (estimated to be 6-7 lac crores incremental deposits as a result of demonetisation), market disruption would be minimal.
4. From a balance sheet perspective, RBI will now have 2.5 lac crore of equity on the Asset side, against a 3 lac crore increase in Reval a/c on the Liability side, effectively providing a MTM cushion of 50k crores for the equity exposure. 

This, effectively would obviate the need for RBI to pay a dividend to the government, while achieving the aim of recapitalising banks. 2.5 lac crores of additional equity, plus incremental revenues out of system liquidity going up will likely cover 50-60% of incremental capital required by banks today for Basel III.

Issues? Biggest one is of moral hazard of the regulator owning equity in banks. While this is valid, the fact is RBI held the sovereign stake in State Bank of India till very recently. The government can in unison also start work on a series of legislative actions to facilitate a transfer of this equity from RBI to government in a reasonable amount of time. 

Is this the best solution? Given the circumstances, and given the enormous disruption to the economy due to demonetisation, it would be a shame if this opportunity was not taken to clean up banks and make the financial system ready for a fresh trajectory of growth.

Sunday, November 13, 2016

Demonetisation Bikini - forget black money (its superficial), real impact is a banking bailout (vital)!

Its been called India's 9/11, surgical srtike on black money. But in reality, demonetisation is India's version of TARP, the post financial crisis (2008) US bank bailout programme. Black money is really a superficial sideshow. How?

Black money - the superficial

Look at the numbers. At a macro level, total currency in circulation (C) in India, per RBI is ~17 lac crores. 500/1000 rupee notes constitute ~85% of this stock, or ~14.5 lac crores (USD 220 billion). Estimates of black money, whether Baba Ramdev (70 lac crores, or USD1.2 trillion), or World Bank (which estimates it to be ~20% of GDP annually, or USD400 billion annually), are a very large multiple of any putative number derived from the stock of currency in circulation. Ergo, the black money discussion is really rhetoric, and only for public consumption.

Bank bailout - its vital, its big

Again, look at the numbers. 14.5 lac crores of demonetised notes can be classified into 3 categories.

  1. X: Genuine, tax-paid currency in circulation required to grease the wheels of the economy. How much should this be? Currency in circulation constitutes ~13% of total money supply (M3). Comparable economies (China, Malaysia, Indonesia) have a ratio close to half of this. Ergo, lets say that half, ie, ~7 lac crores would be reconverted into new notes in the system.
  2. Y: Tax-avoided money, but used in legitimate businesses. Typically, there is seamless flow of this liquidity to and from the "white" economy.
  3. Z: Tax-avoided money, either from illegitimate sources (laundering, corruption, terror etc) or as stores of tax-avoided wealth.
Lets assume, for want of any better data right now, that Y and Z will be equally split, ie, ~3.5 lac crores each. Now, what happens to the money?

X would be tendered back to the banking system, either to exchange back into new notes, or bringing that part of the business in the "cash less" domain. Y too would largely come back into the banking system, either by making it legal (paying penalty/tax) or through various jugaad means.

Z, on the other hand, will be partly converted into alternate stores of value (Gold, Real Estate), but a large chunk will simply be burnt up in the air. Lets assume at least 60% of this, ~2 lac crores, blows up in thin air.

Impact on bank capital/finances

Given the restrictions on withdrawals expected to be in place for some time, bulk of X+Y (10.5 lac crores), say 75%, will lie as bank deposits for at least 6-7 months. At a modest NIM of 4%, that translates to ~16,000 crores of extra profits for the banking system. In the longer run, even if a modest 30% of these deposits (or 3 lac crores) remain in the banking system for good, it generates incremental 12,000 crores of profits for the system. As a comparison, the total budget for recapitalisation of banks this fiscal is 25,000 crores.

Next, Z. The money that is "burnt away"(2 lac crores as estimated above), or doesnt get tendered back into the banking system, extinguishes a concomitant liability in RBI's balance sheet. Extinguishing of the liability without any change in assets means RBI's reserves go up by the same amount. Whether this money can be paid as dividend to the government is up for debate, but there is no doubt that RBI will have a higher reserve that could be deployed. An obvious use could be to recapitalise banks, as CEA Arvind Subramaniam suggested in the last economic survey. Whether as a fiscal boost or as a straight capital injection into banks, the impact is large and meaningful.

Last, bond yields. Demonetisation imparts a deflationary shock to the economy. With 13% of M3 effectively withdrawn for a period, demand for a variety of goods and services will go down, thus reducing prices. Additionally, enhanced liquidity with banks and a fiscal boost for government both impact yields positively (downwards). Biggest beneficiaries of downward trending bond yields are banks, that can make large treasury gains out of their holdings of SLR securities (government bonds, which is ~25% of the total balance sheet of banks). Again, its a positive blow for bank finances.

Net net, whichever way you carve the data or assumptions, this isnt about black money. This is all about a banking system bailout, intended or otherwise. Bankers working hard over the weekend would do well to remember!

Thursday, October 6, 2016

Surgical Strikes - "Rashomon" tactical value, but large strategic impact

In the best of times, India’s strategic capabilities and posture are a case of Rashomon (the Kurosawa classic) – different actors/observers have a different version of the facts! The recent surgical strikes carried out by Indian Army on targets in Pakistan has brought this out again in sharp relief.

The biggest debate around in newspaper columns and TV studios has been around the scale of the strikes, and the strategic/tactical utility of the same. Many analysts, certainly the international media have tended to conflate the two. Pakistan’s outright denial of any strike having taken place has provided more grist to the “much ado about nothing other than marketing” mill. It has also led to widespread clamour, including from political parties, for the government to come out with “proofs” that the strikes indeed took place. However, this misses the point completely. The latest operation has laid bare a few knotty strategic logjams for India (and opens a few plausible windows of opportunity), regardless of how “big” the operation was – and that is what the dominant impact really is.

Debunking “LoC is the Pak nuclear threshold” hypothesis
One, it throws open the long-held putative Pakistani nuclear threshold, one of crossing the LoC. Since Kargil, and Pakistan’s publicly hectored redlines articulated then (and several times thereafter), crossing the LoC has been part of an inviolable nuclear threshold for the Indian establishment. Contrary to what the Congress party alludes to (“there were multiple cross-LoC strikes during UPA regime”), or even what certain scholars opine (like Vipin Narang in a The Hindu op-ed ), In India's calculus the Pakistani nuclear threshold was cast around the LoC. It’s a position that has been axiomatic – articulated in great detail by credible sources like Jaswant Singh (in his many books), Gen VP Malik (in his book and many columns) and Brajesh Mishra (in his many interviews). It has been a hypothesis tested multiple times – Kargil certainly (when IAF planes had to take extreme and unrealistic flight trajectories to conform to “don’t cross LoC” principles), but also during Op Parakram and 26/11.
This operation has in many ways disproved that hypothesis. It breaks out of that pompously worded “strategic restraint” doctrine, which in real terms has been a tiresome “terror strike-loud talk-dossiers-diplomatic activity-pipe down” routine that masqueraded as clever strategy. It also opens up options that India could explore – pushing the envelope all along the 760 km LoC, at various depths, to hurt Pakistani Army interests and that of its terror proxies. Using the present template, each action could be carefully constructed around the military-diplomatic-political lines to maintain a handle on escalation. While not easy, it gives India options to explore ahead of inaction!

Strengthening the Pak civilian regime against the military
A long running chestnut of Indian grand strategy towards Pakistan has been the idea that while civilians want better relations, the Army has vested interests in preserving status quo of violence. The fundamental issue however, even for optimists, has been our complete lack of leverage to change the military-civilian power equations in Pakistan. India’s engagement efforts have fallen between a presumably willing Barkis (politician) and a definitely unwilling Peggoty (military)!
Calibrated cross border strikes, accompanied by diplomatic outreach supporting such actions, perhaps give the first seeds of some leverage in the equation. The equation is complex, but plausible. Limited cross-LoC actions against terror assets (people, camps, launchpads),
a)      Don’t constitute an attack on Pakistani state.
b)      Technically don’t constitute a violation of the border (LoC is a formalised ceasefire line, not the international border).
c)       Leaves little options for proportionate response with Pak Army, besides heating up LoC or organising terror strikes.

Any of the options (in “c”) exercised only goes to increase Pakistani isolation internationally, with very little global appetite for a shooting match between India and Pak, even less for terrorist action. In effect, the burden of a portfolio of bad choices – either counterproductive action, or no action at all – is shifted to the Pak Army. This gives real opportunity for the civilian establishment to garner political space, telling the Army that their actions are only leading to greater isolation of Pakistan besides leaving the LoC vulnerable to Indian actions at a “time and place of India’s choosing”. 
The Pak Army could choose to press the pedal on massive escalation, but any escalation leading to full scale war is a hugely sub-optimal outcome for a military enjoying fruits of a vast commercial enterprise.
The report in the Dawn newspaper todayabout a showdown between the civilian and military establishment may be early tea leaves, but an optically defanged/chastened Army provides the best opportunity for the civilian establishment to grab political space.

Disabuse the narrative of “lack of capabilities”
A long-running theme amongst the commentariat, including ex-servicemen, around India’s strategic choices to Pakistani-sponsored terror has been an ostensible lack of capacity/capabilities. In the morning of the day the surgical strikes happened, Adm Raja Menon wrote (yet another) expansive lament on the state of Indianmilitary capabilities, concluding - "No helicopters, no integration, no intelligence, no training and no operational concept."  The fact is, India’s spent considerable amount of money upgrading the military over the last 10 years. Not all of it was efficient, not all gaps have been addressed, but the sheer scale of India’s spends dwarfs what Pakistan’s anaemic economy could have afforded, even with US funding.
This operation, put together (from what we know) a sophisticated package of capabilities – night flying choppers, satellite surveillance, drone coverage, large SF teams across multiple disparate targets. Add to it inter-agency cooperation – NTRO/RAW on specific intelligence, MEA on coordinated communication with the world – and the picture that emerges is one of a high order of competence in executing the operation in the politico-military domain.
Deterrence is about public knowledge of the quality of capabilities. The enemy is likely to think harder about adventures if he is convinced about the superior quality of our retaliation. Unfortunately, the general narrative around Indian military capabilities is around shortages, lack of inter-agency cooperation, non-functional equipment, lack of hi-tech. Never mind the fact that shortages and all, the Indian military fields a very strong force, and in this case, isn’t facing an adversary with US-level of resources but one that is a nearly bankrupt economy.
The overall optics of the operation created some cracks in that narrative. As Kargil showed to India, information warfare, controlling the narrative, is a vital part of war-fighting.


Tuesday, September 20, 2016

Countering Pakistan-backed terror - a problem of Group Think?

One more attack, another round of testosterone-filled news TV shows, Social Media chatter and ostensibly sober analysis/reportage (hard to discern between the two most of the times!). But déjà vu remains the dominant narrative. Whether the "hard power" realists (Praveen Swami), or the "south asia" idealists (Sidharth Vardarajan) – the group think of the strategic literati coalesces around the known conclusions.
  • Primarily, and this is the strategic overhang, Pakistan’s nuclear threshold is extremely low, and they have a declared “First Use” policy. This renders any military operation moot.
  • India lacks the overwhelming military superiority to punish Pakistan.
  • India lacks (or has wound up, depending on the version) covert capabilities within Pakistan to mount targeted punishments within.
  • “Limited operations” are an oxymoron, as India lacks the capability to dominate every step of the escalation ladder.
  • India’s inter-agency planning is absent, rendering us incapable of/unable to carry out any meaningful intervention.

Effectively therefore, “grin and bear” is the only viable policy option!

Its Group Think perhaps, but the level of consensus and lack of imagination is breathtaking. It follows the dictum of creating options with tools that one wishes to have rather than tools that one does have. As Donald Rumsfeld said, “you go to war with the army you have, not the army you might want or wish to have at a later time”.

First, the big variable in the equation, of a low Pakistani nuclear threshold. The assumption attributes a level of irrationality to the Pakistani Army that is unreal. The Pak general staff, as well as the larger officer corps comprise the socio-economic elite in Pakistan. Their control over levers of power and economy (Fauji Foundation and its affiliates form the largest commercial enterprise in the country) give them a lifestyle unprecedented outside of military dictatorships. As Christine Fair notes in her book, Fighting to the End, the enmity/antipathy towards India is what maintains this resource-grip of the military. The key question therefore is, why would a rational officer corps risk its enormous privileges through suicidal actions? Outcomes of a nuclear exchange is a scenario that is tough to war-game, and generally without precedent and history. 

Further, time and again, the Pak Army officer corps has shown remarkable flexibility at self-preservation at the cost of ideology. Whether turning its back on the Taliban after 9/11, Musharraf’s famous “no need for us to be Islamic soldiers” speech after the Parliament attack, or indeed abandoning East Pakistani defences to a small light infantry force without air/naval cover and virtually no armour in 1971 – the pragmatism of the Punjabi officer corps has shone through.
Ergo, the assumption that nuke-tipped Nasr missiles will start flying in the moment India undertakes any operation is alarmist fantasy rather than rational probability. Once accounted for as such, the menu of options available to India expands.

Once we get over the “low nuclear threshold hump”, the next question is really whether our objective is to break down Pakistani state's will for terror support, or demonstrate to them (and India's domestic constituency) that “enough is enough”. Its an important distinction, as the former requires a level of plausible deniability in public (so that the Pakistani establishment retains some room for an eventual compromise). The latter on the other by definition needs to be loud, public and with enough optics to send the message through.

Fortunately, there is room for us to exercise both.

On the second (public response) front, Pakistan is a state that is vulnerable at multiple points, most notably water. Abrogation of the Indus Water Treaty, an option sometimes talked about, none as eloquently as Brahma ChellaneyStarting to turn the tap off, literally, results in multiple pressure points on Pakistan. The tautological impact is a cascading effect on the economy of the Punjabi rural heartland. Importantly, this is not just the politico-economic centre of Pakistan, but also the primary recruitment pool for the Pak Army. The Punjabi peasant communities dominate the rank and file, and much of the officer corps as well.

Abrogation of IWT is not an optical military threat, hence doesn’t give a visible military objective (let alone justification) to the Pak Army to initiate military operations on. At the same time, it hits the Pak Army close to its home, quite literally. At the same time, it is a big bold initiative to signal a retaliation (for public consumption).

In a nutshell, it generates a public demonstration of India's intent, and the immediate ostensible challenge to be countered would be diplomatic (as Pakistan takes the matter to the international community).


That brings us to the last, but not the least, factor, of trying to bend the will of the Pakistani state. Here, past experiences are relevant, notably from arguably our most successful counter-insurgency campaign ever, in Punjab. Two tactical innovations from that campaign would be useful to recollect.

One, during the mid ‘80s, at the peak of the Khalistan insurgency, RAW set up a covert unit (CIT-X) dedicated to inflicting tit-for-tat damage in Pakistan. Written about in some detail by B Raman (including in his book, Kaoboys of RAW), the modus operandi was simple. For every terror incident in India, this unit would carry out retaliatory attacks in Lahore, Multan and Karachi. It increased the cost to the ISI significantly, and Pak support to the Khalistani groups gradually rolled down. According to Raman, it was a major factor in India’s success in crushing the Khalistan movement.

There are enormous possibilities of renewing this model. The key terror leaders, the likes of Hafiz Sayeed, are perhaps beyond the reach of India's current capabilities. However, individual Pak Army/ISI officers, and their personal properties/business interests are not. Pak Army as an institution, and officers personally, command vast commercial interests in Pakistan, as well as around the world in Dubai, UK and US. These are public, vulnerable and open to subversion.

Two, when KPS Gill took over the leadership of the Punjab Police, the biggest challenge for the force was the safety of the families of policemen, typically in the rural heartland. The force devised an ingenious counter - families of known, Pakistan-based Khalistani terrorists started getting picked up by the Police. It had an immediate, dramatic impact. Attacks on policemen's families stopped, and many of the terrorists came back to India to negotiate a deal with the government.

Can this model be examined with respect to key perpetrators of Islamist terror (and their supporters) based in Pakistan? Terror networks and Pak Army have large networks of friends, families and interests spread all over the world. If reaching them within Pakistan is an issue, reaching them outside Pakistan should not be as big a challenge?

In the medium term, given the nature of the Pakistani state, the only real motivation for members of the same to bend to India's wish will be when they are hurt at the personal level.

Net net, there is a lot that we can draw upon, from our own experiential kit of counter insurgency. Key would be use perhaps a little bit more imagination out of the confines of Group Think!

Friday, August 26, 2016

Misselling and more – Narcissism of large (but non-understood) differences

The most talked-of and debated element of financial services is the spectre of misselling by financial intermediaries, especially banks. Investors are agitated about it, regulators fully engaged with the issue, and above all, the popular media finds it a fertile ground for interesting coverage. Like most matters technical though, the mass media commentary is conspicuous by its lack of understanding of the basics, leading to much ado about very little on one hand, and missing the elephants on the other.

The latest in the series of "misselling scoops" is a study published by Mint, somewhat presumptuously titled 

Here is proof that banks mis-sell

For an article based on a claimed "academic survey", its a rather strange claim to make. Typically, market research surveys, whether on consumer behaviour (widely used by marketers), or indeed on elections seen frequently, are indicative. They are NEVER claimed to be definitive proofs of results/outcomes. Products often bomb in the market, election predictions often go wrong - simply because sampling is often variable, standard errors often large, and data interpretation frequently tricky. Therefore to posit a survey as definitive proof is a rather non-academic approach!

Now, on to the survey. Lets start with the research survey design. 

Survey Design
One, the survey is restricted to one city, Delhi, and excludes a large universe engaged in the Wealth Management space (foreign banks). Given that the Null Hypothesis of the survey WAS NOT "Private and Public sector banks in Delhi missell", its a rather elementary error.

Two, and somewhat less elementary, is the profile of "surveyors". The paper says that some of the surveyors were only graduates, some post-grads. And they had to be "trained on basic financial concepts, on the plethora of tax-savings products available in the market, and on how to ask for advice in the bank". Mystery shopping on technical questions are almost never done by novices. Given that questions and their answers are open to interpretation, follow-up questions require a degree of understanding on the issue at hand, these invariably need to be carried out by folks who have typically "been there done that". Surveys on airline pilot safety behaviour, for example, is never carried out by folks who have been trained for a couple of days on an X-box aircraft game! 

Now, lets see some of the key assumptions underlying the survey.

Hypothesis of banks as “financial advisors”
The study starts off with the hypothesis that banks (and bankers) need to act as advisors, assessing the financial situation of the client, do needs analysis, future projections and then recommend suitable products. These indeed, come under the fiduciary responsibility of Investment Advisors (IA). However, bulk of financial intermediaries are NOT certified as IA at all, but only as distributors, many as simply corporate agents of the tied Insurance Company! Neither distributors not Corporate Agents of Insurance are responsible for, indeed even authorised to, indulge in financial planning activities. Extant SEBI regulations are quite clear on that point. Its a bit like doing a survey in a sample of a mix bunch of general physicians, specialist Orthopaedics, nurses and hospital janitors over questions on knee replacement surgery!

The study however does no stratification of the sample to ascertain whether the bankers tested are certified as advisors, distributors or corporate agents! Most likely, a vast majority of bankers interviewed are not certified as advisors at all. A large number of (especially PSU) bankers might not even be certified as Distributors.

Ergo, it is but natural that non-certified bankers would simply point out default options (like FD) to clients looking for open-ended “tax saving” instruments. It is also understandable that bankers that are only certified as Corporate Agents of a tied Insurance company would tend to suggest insurance policies – they are massively popular as tax-saving instruments (and the popularity predates the current brouhaha over misselling).

Key issue is simple – the survey assumes that all bankers are qualified and appropriately certified to be IAs, and expects appropriate fiduciary behaviour from them. The fact is that extant regulations don’t permit such universal coverage, and for good reason too.
While the study loosely references regulations like UK RDR, it seems to have had no appreciation of differential roles and responsibilities intrinsic to the make-up of such regulations. The basic rationale and premise of the survey, hence is problematic.


Force-fit comparison of wildly divergent products
FD, ELSS, Endowment Insurance, ULIP – the study takes four wildly divergent product categories and force fits a “choice” between them. Finance 101 tells us there’s none at all. All these products lie at different points of the CAPM curve, some don’t at all – Insurance products have bundled protection elements that make their payoffs rather non-linear to fit into a CAPM curve.


Three, attribution of “costs”
The study starts off by making an astounding claim that bank FDs have “zero cost” to the investor. All banks would be out of business if that were to be true! Banks make a margin over and above the cost of deposit plus a credit charge – that’s how the bank makes money! Banking 101, missed by folks who haven’t been bankers themselves J. This gross misinterpretation is symptomatic of the general understanding of “costs” on the part of the survey.

For 3rd party products, the survey conflates the issue of intermediation costs with total costs of investment products. Investment performance, in inflation (and tax)-adjusted terms is a function of total costs in-built. Intermediation costs are a subset of total costs, and is simply a retrocession from the latter. Comparison using incomplete subsets is an obvious mistake that even a non-academic study would avoid.

The biggest bugbear of the study being Insurance, the study never discloses the total 20 year costs of an insurance policy, compared to the total 15 year costs of an ELSS (MF), or 20 year costs of FD. As a result, misses multiple issues with the formulation. First, the animal of a “20 year FD” practically does not exist. Banks do not raise ultra long tenor funding. Ergo, with differential tenor, comparing costs are a non-sequitur. Second, neither FD nor ELSS have bundled mortality covers that Insurance policies have. The authors could have (and should have) unbundled the mortality charges to arrive at comparable costs. Third, ELSS are equities-only products. Held for 15/20 years, they wouldn’t reflect the changes in risk profile that an individual undergoes over such long periods (ULIPs typically have asset allocation features to take care of this). Again, comparison therefore stands to be rather moot.


Net net, for a survey-based study that is so full of gaffes, the news report rather presumptuously claims finality and proof for its null hypothesis. Fact is, misselling is a complex issue, doesnt lend itself to simplistic formulations and "only" survey-based answers. Unfortunately, such conclusions result in erroneous conclusions, builds the wrong perceptions, and becomes a huge hindrance to market development. 

Friday, July 1, 2016

NSG and after - the naive search for free options?


The general thread of wisdom that descended upon us in the aftermath of India’s stalled bid for NSG membership was notable in but one matter, ie, déjà vu. Why?

One, it confirmed the oft suspected view that Indian Sinologists are really Sinophiles.
Two, it regurgitated all the old concepts – China’s working around its own self interests, we need to be more aware of our own (lack of) leverage, this further shows the perils of high profile diplomacy, we need to build areas of leverage for us to get favourable outcomes in such endeavour.

But in our overwrought self-confidence, we risk the worst of both worlds: Not having enough fire power to really hurt any of the powers bigger than us on the one hand; at the same time frittering away the cautious virtues that actually have stood us in good stead. 
The India-China relationship has been diminished by these latest developments and their impact on the construction of a stronger edifice of bilateral interaction. Independently of the latter, we need to carefully assess the pros and cons in pursuing entry into the NSG in this current phase. On both fronts, a season of reflection is called for.
However very little of the analyses dwells on solutions, ie, what should India do different/better/sharper beyond an indeterminate wait to “build leverage/capacities”?

Tied intimately to such analysis is really the search for “free options”. In other words, a search for variables/capacities where we can attain our objectives without giving in to “core principles” (generally defined in terms of maintaining arms length from the US and minimising friction with China). Usually, these include equidistance from all major powers (US, China, in some cases Russia), maintaining dignified multilateralism in our dealings in multilateral fora, recognise that China is a great power and keep engaging with it. And yes, hell, we shouldn’t be “narcissistic”!

Unfortunately, as much in life as in the arcane world of finance, free options are usually worthless. No one sells them, the gullible buy them for value, and only the very naïve try to create such options. The mismatches in Sino-Indian national power equations are not going to be equalised in a matter of years, even decades. In the meanwhile, China’s approach towards present and incipient rivalries is only going to be more exploitative of such asymmetries. No amount of patient “engagement” will change this reality. The search for free options is a chimera extending beyond lifetimes.

Its almost tautological that compromises need to be made, prices need to be paid for achievement of key objectives. In other words, valuable options have a price. Ironically, some of India’s best foreign policy successes required purchase of such expensive options, and we did so with aplomb.

Bangladesh, 1971. One major power (US) had aligned interests with Pakistan, largely misaligned with our non-aligned status, compounded by the personal distaste between President Nixon and PM Indira Gandhi. To counter that, Indira Gandhi entered into the Indo-Soviet Friendship Treaty in 1971, buying insurance against US military intervention. The price paid was steep – India pretty much gave up all pretences of “non-alignment” in practice. There was not even any lip service paid during the Soviet intervention in Afghanistan.

Shakti nuclear tests. It was well known that the tests would bring in wide ranging international sanctions, and India in 1998 wasn’t the India of 2016 in terms of trade/economic muscle. But the Vajpayee government pushed on, and paid the price in terms of delayed economic growth (GDP growth didnt recover till the second half of NDA-II) and money (writing out a big cheque in raising the Resurgent India Bonds). 

Valuable options on building leverage over China today have similar prices that need to be paid. What are some of those options?

One, a firm alignment to the US pivot towards Indo-Pacific, at least to certain elements of it. Joint patrols with the US Navy in the South China Sea, ramping up of trilateral Malabar exercises and taking an unambiguous stance on the freedom of navigation issue. This could also include a more vigorous level of activity on the exploitation of Vietnamese offshore oil blocks.

Two, use India’s board seats in the new China-led multilateral financial institutions, notably AIIB, to constrain funding/progress of flagship Chinese projects like CPEC/OBOR. Institutions like AIIB and BRICS Bank are being sought to be used to supplement Chinese sovereign funding for these projects. As founder members and large (2nd largest) shareholders, we should actively look to disrupt such projects.

Three, take the Tibet issue off the ice slab that we have put it on for long. The real Indian leverage that China is truly worried about the seat of the Dalai Lama, and a strong military force in the form of the Special Frontier Force (built around a core of Tibetan emigres), led by the Indian Army (the current Army Chief, Gen DalbirSuhag was IG SFF earlier). The “dissident conference” in Dharamshala earlier this year was a tentative start, overshadowed by the Dolkun visa issue. There’s scope in calibrating the visibility of such initiatives upwards.

Above all, an alignment with the US, even at levels short of the erstwhile Indo-Soviet Friendship Treaty, would act as a significant leverage to deal with China. Is there a large price to pay, even beyond mere principles? Of course, there would be. But it is often forgotten that even formal alliance membership doesn’t preclude serious opposition on key foreign policy goals. Turkey is a NATO member, didn’t prevent it from not joining the US war in Iraq, or being on the opposite side in Syria. France, a historically close ally and NATO member, has frequently clashed with the US on critical foreign policy issues. The cherished independence of foreign policy is not dependent on membership of groups, but on the conduct of policy itself.


There would be prices to pay for overt opposition to China too, whether on AIIB board or around Tibetan dissidents. That could take various forms – a larger military presence on the borders, greater military aid to Pakistan. Again, the level at which we buy these options and hence the price we pay is something we can evaluate. In many respects, they will lend themselves as bargaining chips that could be be used with China.