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.


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%
      34%


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.