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.

Saturday, June 11, 2016

Quest for NSG membership - banality of real outcomes?

Arcane nuclear alphabet soups are back in media fashion. For once, with good reason, as India has mounted a high profile, energetic campaign to get membership of the Nuclear Suppliers Group (NSG), the informal club of 48 countries that regulates global nuclear trade through regime of voluntary compliance to agreed rules.

In a way, membership of NSG (as well as of the other 3 groups - MTCR, Australia Group and Wassenar Group) would mark the culmination of the process of India's de jure admission into the global nuclear order, a process that started with the India-US Civilian Nuclear Agreement (famously known as the 123 Agreement) and the "clean waiver" from NSG in 2008.

From available indications, China is the standout objector to India's entry, insisting on a process for Pakistan's admission as a proxy to block India's admission to NSG (all decisions in NSG are through consensus, ie, every member has a veto). Drumming up support for India's cause was a key theme running across PM Modi's 5-country tour recently.

The amount of diplomatic energy spent on this effort is puzzling though. Lets study some of the facts on the ground.

In 2008, India received what is now popularly known as a "clean waiver" from NSG. Technically NSG, in an extraordinary plenary meeting, adopted a Statement of Civil Nuclear Cooperation with India, which outlined a set of rules/guidelines enabling all member countries to engage in trade of civilian nuclear technology and materials with India. Under the arrangement, in exchange for bringing a substantial number of nuclear facilities under IAEA safeguards, India could trade in nuclear material and technology "legally" with all member countries, and access all technologies that an NSG member-country would have access to.

Now NSG guidelines are voluntary, and technically member-countries can (and often have) enter into contracts outside the same. Most notably, Russian supply of fuel for Tarapur in 2001, contracts for Kudunkulum 1/2, Chinese supply of reactors to Pakistan (Chashma 1/2) are instances of that. But of course these deals are exceptional in nature, and cant be a template for a scalable civilian nuclear business. The "clean waiver" in 2008 enabled exactly that for India.

Soon after, India entered into agreements with dozens of countries for supply of nuclear fuel/tech - from Kazakhstan to Canada to Australia. The results have been dramatic, and Plant Load Factors of Indian nuclear power plants have increased significantly as Indian nuclear power plants have had "free" access to imported Uranium.

There hasnt been any major movement on new imported reactors though, but that has been primarily on account of the Indian Civil nuclear liability law, a legislation (borne out of Parliamentary pressure brought in by a coalition of the Left and BJP) that scared away pretty much all major nuclear operators in the world.

In 2011, there was a minor flutter when the NSG adopted new guidelines on trade in sensitive Enrichment and Reprocessing (ENR) technologies, restricting it to NPT members. It was widely feared that this annulled India's "clean waiver". However, French, American and Russian interlocutors (main potential sources of ENR tech) clarified that India's waiver isnt impacted by the new rules, and India would continue to have access to ENR technology if we so intended to. Big point though is, the Indian nuclear scientific community isnt in any hurry to tap into imported ENR tech as a priority.

Ergo, since 2008, India has derived all commercial benefits of an NSG member-country, without actually being a member. Ergo, the question really arises, why the brouhaha today on membership? The proponents generally postulate three main benefits of having a seat at the table.

One, as an insurance policy. By becoming a member, India will have a voice at the table. NSG would not be able to take decisions that adversely impact India without our consent. The fear is overblown. As mentioned earlier, NSG works on consensus, ie, every member has a veto. Given India's heft in international politics and trade, it would be a black swan scenario to have 48 member nations unite on guidelines that adversely impact India. As India's trade in nuclear reactors is kicked off, there would be commercial handcuffs with major powers (US, France) that would act as bigger and better insurance policies.

Two, it enables India shape the global nuclear/disarmament architecture. This is the ostensible objective with perhaps the least synchronicity with India's strategic posture. At the cornerstone of the global nuclear architecture is the Nuclear Non-proliferation Treaty (NPT). Given the discriminatory nature of NPT (India cannot join as a Nuclear Weapon State), India's deliberate approach has been towards creating strategic space for itself through exceptionalism rather than shaping the global rules per se. The NSG clean waiver fits nicely in that framework. Given the near dogmatic status of NPT, membership of adjunct voluntary "clubs" like NSG affords very little opportunity to shape the global order.

Three and last (also the least), it gives India a seat at the "high table". "India's rightful place in the comity of nations" has been a freedom movement paradigm. Implicit in the objective has been membership of global rule-making platforms - permanent membership of UN Security Council, G20, Bretton Woods institutions, global Trade blocs. The issue though is, NSG is neither a proper table (its voluntary), nor is it particularly high (48 member countries, including Argentina, Mexico and Austria among others). It represents multilateral democracy at its zenith (each member having a veto), and consequently is least amenable to great power deal-making that is essentially based upon exceptionalism and vested interests.

Net net, while membership of NSG is a worthy goal, there isnt a big material win" at stake for India, over and above what we already have. The outcomes of membership are likely to be rather more banal than what the breathless commentary seems to suggest!

Friday, June 3, 2016

Banking reforms - barking up the wrong tree?

Banking reforms has been on top of the mind of the government, media and in general the commentariat over the last 3 years, gaining decibel in line with deteriorating balance sheets of banks. A recent op-ed piece by Prof Ajay Shah in Business Standard encapsulated the commonly thought of issues with banking, and the roadmap of what is popularly believed to be “reforms”. Prof Shah essentially makes the following points.
  1. There isn’t enough competition in banking, and we haven’t got enough new entrants coming through. This is affecting service delivery, both quality and quantity.
  2. Banks dominate the credit markets, lack of a developed corporate bond market is crowding out bank credit to SME (unlike in “mature” markets).
  3. Lack of a developed bond-currency-derivative market is preventing efficient transmission of policy rate movements.
Unfortunately, all the three identified issues (and their putative reformative solutions) are either misdirected (ie, not linked to revitalisation of the banking system), or completely wrong in its premise per se. Given that these are the Generally Accepted Banking Solutions (GABS!) of the "liberal" commentariat, it is important to put the hypotheses through some basic rationality tests.

Competition - too little, or too much?
First, on the question of competition. We don’t have enough banks, and too few new ones are coming through in scale. 

Data simply doesn’t bear the hypothesis out. There are ~100 commercial banks (Publicsector, private sector and foreign banks), a few dozen Regional Rural Banks(RRB), and hundreds of Cooperative banks (of various types). Very few countries (outside of US) have such proliferation in sheer numbers of banks. Ergo, lack of competition isn’t the most burning issue plaguing the industry.

Far from not having enough banks, India has an issue of far too many banks. So is the issue of regulatory walls creating a few large oligopolistic banks while the industry has a long tail of small banks? Far from it. Barring State Bank of India with a marketshare of ~20% and ICICI Bank (with a shade lower than 10%), all other banks have marketshares in low single digits.  The big issue therefore being that very few of whom have scale economies to drive down intermediation costs and offer competitive services to customers.
From a “reform” perspective therefore, the key imperative isn’t new banking licenses or more foreign banks coming into India, but a more enabling M&A framework that would enable consolidation of banks into large, scalable entities.
Prof Shah’s favoured exemplar industry, telecoms, had exactly the same enabling consolidation roadmap for penetration and costs.

Corporate Bond market - "crowding out" small borrowers?
Second, in absence of a well developed corporate bond market, most of corporate credit is financed by banks, thereby “depriving” SMEs of banking credit. To start with, the hypothesis is again incorrect. 

Loans above 100 crores contribute only around 31% of totaloutstanding banking credit. Ergo, ~70% of credit is going to medium and small sized enterprises and individuals.

Moving on, the premise itself is incorrect. Most large corporates in India do have access to a corporate bond market, both onshore as well as offshore.

As seen in the chart above, the corporate bond market in India is actually quite in line with Asian peers, accounting for ~30% of all outstanding bonds. Above all, the share of banking credit to overall credit outstanding in the economy too is in line with relevant Asia peers.

There is a structural issue with the savings market in India . Simply put, savers in India prefer banks over anything else to deploy their savings (bank deposits account for ~50% of all household financial savings).

With banks having access to the largest pool of savings, its but natural that they will have the largest share in credit, tautologically!

Net net, while access to credit is always a work in progress, lack of corporate bond market isn’t the elephant in the room. 

Lack of Bond-Currency-Derivative market preventing monetary policy transmission?
Third, lack of a bond-currency-derivative market prevents effective transmission of rates. While as a structural issue, lack of a derivative market in bonds (CDS) and a liquid enough market in Currency (more INR trading happens in the offshore NDF market than in India) are constraints, the immediate issue on rate transmission is a lot more quotidian.

Simply put, PSU banks (that are 70% of the banking system) have ~12-13% of assets classified as stressed. As a result, all of them are stretched on capital (remember Tier1+Tier2 capital on an average would be 10-11% for these banks). Given the lack of "free capital", the banks are unable to grow their loan books. Now if they repriced existing good loans downwards, it will only have one impact, ie, a drop in Net Interest Margin (NIM) and hence profits. In a more normal environment, the banks would compensate through growth in their loan books. But in absence of balance sheet/capital space to do so, there would be only one outcome, ie, a drop in profits. A drop in profits would mean a further reduction in retained earnings, further reduction of Tier1 (equity) capital. Ergo, its a vicious cycle. It is thus very normal and rationally explained why policy rate cuts are being transmitted through the system so anemically. No amount of market development in products would solve an issue primarily linked to capital adequacy.

Its the (banking) capital, stupid!:)
So what is the way out of the current problem? While silver bullets are never available outside of blue TV channels, the US TARP (Troubled Assets Relief Program) launched to rescue banks after the 2008 meltdown offers interesting cues. The issues with US banks in 2008 were somewhat similar to Indian banks today.

  1. Concentration of bad assets in the loan portfolio (it was CDO/MBS there, corporate loans for us in India).
  2. Extreme capital inadequacy to clean up the bad assets and resume normal business growth.
  3. Sharp reduction in valuations/share prices, cutting off reasonable access to capital markets.
The solutions under TARP were a mix of infusion of government equity, sovereign guarantees on liabilities and an aggressive clean-up of bad assets by using the fresh capital. The program was a resounding success. While there were philosophical questions raised about using taxpayer money to bail out private banks, the government of the US earned a handsome profit out of the exercise.

The solutions for India would have to be on similar lines. A problem of banking capital has to be resolved through infusion of capital. Once confidence is restored around the health of the banks, the latter can access capital markets to raise fresh capital at reasonable terms. That will enable the banks to resume normal business. It is that which would make the systemic impulses more efficient to transmission of policy signals down the chain. That would also be a better time to take stock of and decide upon questions of privatisation, mergers and so on.

Sunday, May 8, 2016

Ignore the sophistry, the middle class picks up a predominant share of the nation's taxes

The government recently released time-series data on income tax. While much of the data was known, it sparked off renewed debates on the level of taxation, the small numbers of people paying taxes, adequacy of our tax rates etc. The junior minister of Finance, Jayant Sinha weighed in on the debate in an interaction with journalists/economists, hosted by Swarajyamag. He made a few key observations, some of which merit closer scrutiny.

1. The number of people filing tax-returns isnt as low as the headline number (~4.5 crores) suggests, its a reasonably fair reflection of our economic structure.
2. Levels of tax-rates in India are "moderate", lower than rest of the comparable world.
3. Most importantly, its a mistaken notion that the middle class takes up a disproportionate part of the tax burden, as 50% of the taxes are indirect taxes (that impact all, poor disproportionately), and income tax-to-GDP ratio is only ~22%.

Well, banality of headline numbers is de rigeur with politicians, but one expected somewhat better from Jayant Sinha, with his significant experience in money management. He is right on the first point, ie, the number of tax-payers, once adjusted for agricultural income (and bracketed up on households), is a respectable number. Unfortunately thats where the good analysis ends. 

Firstly,tax rates. The minister would have us believe that India is a "moderate tax" country with peak tax rate @ ~35%, lower than most comparable ones. The examples he quotes? US (25 times our percapita income), UK (20 times).  For good measure of comparability, he quotes China's 45% peak tax rate, forgetting perhaps that China's per capita income is 4.5 times India's! 

Comparing more comparably, India's peak income tax rates are at the upper end of Asian levels. From 25% levels in Malaysia/Sri Lanka to 35% in Vietnam/Thailand, Indian peak tax-rates are more than fair in the context of our geography and per capita income.

In a breathtaking instance of a  bizarre non-sequitur, the minister added that countries like Singapore have low tax rates because they dont have an army! For a government thin on academic talent, Jayant Sinha is an exception, hence its doubly surprising how he missed that Singapore one of the highest defence-to-GDP ratios in Asia!

Now to the contribution of the "middle class" to the overall tax collections of the government. the central government's tax pie looks something like this.

Tax head  INR Crores  % contribution to total
Income Tax           353,173 22%
Corporate Tax           493,923 30%
Excise           318,669 20%
Customs           230,000 14%
Service Tax           231,000 14%
Source: Union Budget 2016-17

Again, banality of the headline number strikes. Only 22% of total central taxes is contributed by income tax. another ~30% is corporate tax, and the balance, a disproportionate (by global standards) 50% is from indirect taxes. Indirect taxes ostensibly are regressive, as has non-linear, asymmetric impact on household incomes (in other words, poorer you are, greater is the impact of the tax levied for buying the same packet of cigarette).

But as usual, the headline number masks the reality.

There are three major components of indirect taxes today are Excise, Customs and Service taxes.

A CAG report from 2013 has good data on the contribution of various commodities and service categories towards excise and service taxes. It is clear from data that indirect taxes, to a large extent, and directed primarily at the "Middle Class", and while not being as progressive in nature as income taxes, are largely borne by the 120-150 million folks that comprise the middle class of India. Lets call this the "Middle Class Tax", or MCT.

To start with, ~50% of all excise taxes are due to petroleum products, primarily petrol and diesel. In other words, ~10% of Excise taxes come from motor fuels. Petrol comprises ~18% of the motor fuel mix, while diesel comprises 82%. As per AC Nielsen, around 13% of all diesel sales, and 100% of all petrol sales are accounted for by private cars and 2-wheelers. Through elementary maths, this means that ~30% of all motor fuel taxes (or 15% of excise taxes = 30%X50%) can be classified as MCT.

Second, Motor vehicles contribute 6% to the central excise kitty - another tax that can be entirely classified as MCT (given that vehicle ownership is termed by politicians to be a "middle class luxury").

Third, service taxes. Its the fastest growing head of tax revenues, and every year new categories of services are included in its ambit. What are the key categories contributing to this kitty today? Check carefully the components (from the same CAG report referenced above). Financial services, restaurants, telecoms, business auxiliary services, insurance premia, construction&renting of property, maintenance & repairs - in short, barrign a few its mostly a laundry list of services consumed in large quantities essentially by the Middle Class. While its somewhat tough to put a precise number, going by the contributing category heads, it would be safe to assume a 60% contribution of MCT in the service tax kitty, in other words, ~8.4% of aggregate central taxes.

Last, customs taxes. Bulk of the contribution to customs come in from industrial intermediates and capital goods. From pure value terms, it would be difficult to directly attribute a progressive direct burden on the middle class alone from these levies. Hence, it would be fair to take a 0% MCT on the same.

Net net, therefore, how does it look?

Tax head  INR Crores  % contribution to total MCT contribution
Income Tax           353,173 22% 100%
Corporate Tax           493,923 30% 0%
Excise           318,669 20% 21%
Customs           230,000 14% 0%
Service Tax           231,000 14% 60%

In other words, MCT accounts for 34% of ALL central taxes directly. This isnt accounting for the share of unattributeable indirect taxes as well as local/state taxes that are contributed by the middle class.

Safe to say that the middle class bears a much larger than its fair share of the nation's taxes, while encountering a tax rate that is at the upper end of Asian levels, and a tax administration that is at the lowest end of the same levels!

A data-challenged minister shouldnt get away with saying anything else!

Friday, April 15, 2016

Indian Mutual Funds - Rising tides raise the ship, fails to hide the rotten hull

Recently, Nilesh Shah, a respected veteran of the industry (and CEO, Kotak Mutual Fund) wondered aloud in a tweet why share of MFs in national financial savings remains low (lower than even cash in the hands/below the pillows of public). For an industry that was meant to be one of the sunrise sectors of the new millennium has been basically been a par beneficiary of growth. Long term trend numbers are impressive, but merely in line with the impressive GDP numbers, and an increase in the level of financial savings in the economy, especially by households.

There were three major verticals in the financial sector opened up for private participation in the first flush of liberalisation  - Banks (1994), Insurance (1999) and Mutual Funds (1993). The results have been illustrative.

Barring a couple of blips (1992, 1999 and 2008), when the share of MFs (and other capital market instruments) touched 9-10% of financial savings, the average (mean as well as median) share has hovered around the 4-5% level. This despite a headstart in terms of private sector participation, significant tax advantages (that continue till date) over other financial instruments and the ready playing arena of a well developed equity capital market. Bank deposits continue their dominant (nearly half) share, while Insurance has steadily gained marketshare from other instruments.

The reasons for this are manifold, with some having become cliches that are repeated ad nauseam. Pensions are the biggest one, parroted out during every discussion. While its a legitimate point, it begs the question though what initiative asset managers have shown since 2003 (the year pensions were opened for private sector) to expand the pensions market. Regulatory progress has been admittedly patchy, but the number of bright sparks from the industry can be compared to those from diwali crackers in Iceland!

In general, the problem is a financial equivalence of the oil curse. So comfortable has the industry been on large, significant tax-breaks on its products (Interest on a bond is taxable at marginal income tax rate, but the same interest paid as capital gains in a MF is taxed at a lower rate. Selling unlisted equity attracts capital gains tax, selling close-ended Equity MFs attract no tax!).

A perverse outcome of the above has been the concentration of institutional and corporate treasury money in MF AUMs. As of Dec 2015,  close to 50% of the AUMs came from Corporates, Banks and Institutions. In other words, the actual share of MFs in household financial savings is half of the topline number shown in the chart above.

Second, complete lack of innovation. The last big bright idea was creation of differentiated share classes (through institutional plans) in 2003/4. Since then, the biggest ideas have been around fees - either on ways of reducing it or packaging products to extract more of it. For an industry that is so new, the commoditisation (reflected on fees being the primary discussion point) has come in rather fast!

Third and last, lack of disruptive technology interventions of the sort that we have seen in banking. This admittedly isnt entirely an Asset Manager issue, but lack of imagination from the MF industry has been stark.

Most developed financial markets have large Mutual Funds shaping opinions and steering savings in risky assets. Lack of adequate movement in India has led to policy-makers and investors looking for alternative vehicles (note AIF guidelines allowing investments in public market instruments, note the discussion around Wholesale Banks). Just as India risks missing the manufacturing age, MFs risk being bypassed while financial savings find alternate routes to feeding risk capital.

Sunday, March 27, 2016

Pak JIT to visit Pathankot AFB - Modi's "Jaswant" moment?

For a government that has been generally pilloried for not being "radical" enough in its policy interventions, the Modi government has lately shown a strange penchant for spending an enormous amount of political capital on small impact initiatives.

The latest of them is the visit of the Pak JIT to India to investigate the Pathankot AFB terror attack. to be sure, this isnt unprecedented, there was a Pakistani Judicial Commission that visited India in 2012 to record the testimony of witnesses. But there are key differences between 2012 and 2016. For one, the composition of the Pak team - this time, it consists purely of police/intelligence officials, including a junior officer of the ISI. But more intriguingly, its the access accorded to the team that is curious. The Pak team will visit Pathankot AFB, though it has been said that they would not be allowed inside the "Technical area" (the part of the AFB that houses aircraft and missile/radar systems). Somewhat facetiously this would be the first time an ISI (and a MI) officer would "officially" set foot inside an Indian AFB.

What isnt quite clear is the purpose of the visit. All terrorists involved in the attack have been killed. The terror scene would have been cleaned up two months after the incident to afford any great forensic work. Witnesses, barring the Punjab Police SP Salwinder Singh (and his two associates) whose car was ostensibly hijacked by the terrorists, most others would be basically "victims" of the attack and personnel posted in the AFB. By definition they wont have much value to add about the Pakistan connection of the attack, which is the purported objective of the visit.

Question therefore is, what is it that the Pakistani team will do that could not have been done over electronic means in terms of data sharing? Or is it just optics to keep the pressure on Pakistan?

Whatever it is, odds are that this would have an outcome not much different from what has been seen in 26/11. JeM, while not being as strategic an asset for the Pak establishment as LeT is, is still too valuable to be given up on a platter. Not when the establishment thinks that it has substantial strategic leverage thanks to China (CPEC deal) and the upcoming US withdrawal from Afghanistan. Especially as there is no quid pro quo on the table from India, either on Kashmir or for that matter on Afghanistan.

For the Narendra Modi govt, this could end up uncannily like IC814, Jaswant Singh escorting the JeM chief Masood Azhar (and two others) to Afghanistan. It was an imagery (of a culmination of bad strategic choices, starting from Lahore bus yatra) that BJP has been hard pressed to live down. As the hardline nationalist party, the BJP has a certain amount of political leeway in making concessions on Pakistan. But optics without tangible outcomes come back to bite hard.

JeM/Masood Azhar seems to be a case of deja vu for the BJP!

Saturday, March 19, 2016

Small Savings rate cuts - How to lose friends and make daft policy

Dogma plays an important role in both politics and economics. After all both are inexact sciences (latter more than the former), hence value of data is always secondary to the primacy of dogma.

Even granting for that though, the decision by the Modi government yesterday to reduce administered interest rates on small savings defies all logic. One, it alienates a core constituency of the BJP, the urban middle class, that was already chaffing at the margins for the Union Budget gaffe on EPF taxation (hastily rescinded). Two, it doesnt even make sense from a purist, macroeconomic standpoint!

Lets go through the market fundamentalist view of why small savings rates needed to come down. The view is simple - as long as households (in other words middle class folks with some disposable income) have alternative savings instruments in the form of PPF/NSC (and other small savings products) with high tax-free interest rates, banks would not be able reduce interest rates on their deposits. So while RBI could cut policy rates, the ability of banks to pass those rates on to borrowers would be circumscribed by the fact that they face unfair competition for deposits in the form of small savings with high interest rates.

Like most market fundamentalist dogmas, the hypothesis doesnt stand basic empirical scrutiny. Lets look at the data on household financial savings in India. Over the last few years, household financial savings have been hovering around the 10% of GDP mark. And they get deployed in a variety of instruments - Bank deposits, shares, Life Insurance, PF, and Small Savings. Look at the composition below.

The numbers are self explanatory. Bank deposits account for a massive 48% of all savings deployed by households in financial assets. Where is that big "transmission roadblock" culprit, Small Savings? Well, its consolidated in the section Claims on Government. And its marketshare? 5.6%! ALL the other components of household financial savings - deposits, insurance, pensions, shares, UTI - are subject to market determined interest rates.

In other words, a small implicit subsidy in 5% of the flows prevents rate cut transmission in 95% of the flows!

This is a classic example of tilting at windmills and brandishing a reformist sword - unfortunately, the financial Don Quixotes have impact far exceeding the spanish dilettante!

Lets also go further and examine the other point - what about the cost to the government of such largesse (towards small savings scheme). The latest Economic Survey has the data.
economic survey for 2015-16_factly.in_implicit subsidy for rich

As can be seen, interest rate subsidy on PPF (the largest, and ostensibly the "unfairest" component of small savings), is ~12000 crores. The other small savings products (PO savings, KVC etc) are used to fund state government deficits, and hence the interest is serviced  by state governments. Lets say that the subsidy on account of all other small savings product is a similar amount. So the total subsidy on account of administered interest rates is ~24000 crores.

For a country with zero social security, is that a big number for rudimentary safety net? In terms of fiscal impact, the notional loss to the government on account of corporate tax exemptions add up to nearly 6 lac crores.

Its clear therefore that purely from an economics standpoint, the reduction of rates on small savings doesnt stand up to basic scrutiny. It seems to be a case of the government giving in to a "financial market populist" demand. However, the political cost of this far outstrips any benefit on the monetary side. For a government that has been so cautious about anything radical, this is a classical "penny wise pound foolish".