Sunday, January 1, 2017

Banking capital - Narcissism of rather major differences

A popular social media chestnut arising out of demonetisation is an estimate of the number of monetary economists in India - in last count, it was 500 million and counting! With such massive proliferation of economists/astrologers, "serious" commentary has shifted to banking. It is being widely discussed that bringing cash into the banking system as deposits is a sinister plan to use the same (deposits) to write off bad loans that Indian banks are saddled with.

Normally, such drivel would be dismissed out of hand. But when "serious media" like The Wire publish monographs by academics, and the theme is picked up by Rahul Gandhi as something that merits his (generally limited) attention, it should be examined a bit more closely.

In (practitioner) financial circles, banking capital is a topic of intense scrutiny, attention and action, especially so after the global financial crisis of 2008. Global blue ribbon standards are set out by the Bank for International Settlements (BIS), popularly referred to as Basel "N" (we are currently in Basel III) norms, and local banking regulators set out their own specific guidelines around Basel requirements.

In a nutshell, various types of capital used by banks to fund their balance sheets look like this:

Senior Secured Debt (very rarely used these days) form the safest form of banking capital. Should a bank go bust, the specific securities earmarked against this debt are liquidated to pay back the creditors.

Next comes deposits of all types - checking (current/savings accounts) and term (also known as fixed) deposits. In most countries, retail deposits form the bedrock of public confidence in the financial system. As a result, regulators create an architecture of "protection" around deposits. To start with, most countries have deposit insurance programmes - in India, it is extended by a govt-owned entity called DICGC. Like any other insurance, there is a cost to this, and hence the amount insured is capped (in India, the cap is Rs 1 lac). Extending the insurance to cover all deposits would make costs prohibitively high for depositors, leaving a far lower amount for them on the table as interest on the deposit.
Besides deposit insurance, the entire structure of the rest of banking capital is used to protect deposit-holders from bankruptcies. Whenever there has been a run on a (major) bank, regulators have quickly clamped down by using equity capital (and sometimes taxpayer money) to bail out deposit-holders. From Bank of Rajasthan to Global Trust Bank in India to Washington Mutual during the financial crisis in US - regulators and governments have tended to bail out deposit-holders. In no circumstance can deposit funding be used, structurally, legally and in terms of regulatory forbearance, to fund a NPA write-off by the bank.

How is the above accomplished? By building in "bail in" clauses in ALL other types of banking capital - bonds, hybrids and equtiy. What is "bail in"? Basically, the opposite of "bail out", ie, investors in these instruments would suffer haircuts, either in principal or in interest due, should defined performance benchmarks are missed.

Even "senior unsecured debt" have traditionally tended to be treated with kid gloves by governments (post Lehman Bros, every single major bank bailout globally bailed out all sr unsecured bondholders, at a level equivalent to deposit-holders). Today though, most new issuances of such instruments have "bail in" clauses. In other words, the bond-holders will be asked to take haircuts if certain (steep) benchmarks are missed by the issuing banks.

There has also been a proliferation of subordinated and hybrid instruments in the last few years. These are typically structured as bonds, and have fixed coupon payments, but have relatively narrow performance benchmarks below which investors start losing interest payments and/or principal. In India, the widely popular AT1 bonds (Additional Tier 1 bonds) are an example of such hybrids. These instruments provide additional cushion in bank capital to absorb losses and provide time and space to regulators to move-in with a revival/rescue plan.

Last, but not by far the least, is CET1 (Common Equity Tier 1) capital - this constitutes primarily of capital and retained earnings of the bank, and form the first loss-absorbers for the banks. Over the last 7-8 years, CET1 capital requirements have been enhanced. Under new Basel III guidelines, banks need to have at least 4.5% of their Risk-weighted Assets as CET1 capital. Traditionally, in India and elsewhere, this capital (and its owners, basically the shareholders) has been the first loss-absorbers.

Total capital requirements, comprising of CET1, Subordinated, Hybrids together, touch double digits today (11-13% of risk-weighted assets, under Basel III). On top of that, senior unsecured bonds increasingly have "bail in" features. Depositors, lying "senior" to all of these, usually have little to fear unless there is an Armageddon scenario.

Net net, deposits, and deposit-holders, structurally, philosophically and in terms of precedent, are NOT the first port of capital call when a bank needs to write-off losses. Money coming into the banking system as a result of demonetisation is coming in as deposits. There might be differential views on demonetisation, but conflating deposits with banking capital is indulging in narcissism of really major differences, with due regards to Sigmund Freud!

Saturday, December 24, 2016

Appointment of Service Chiefs – the military doth protest too much, too unfairly

2016 has been a year of controversies for the Indian military. From the fracas over OROP to the putative responsibility of ACM Tyagi in the Agusta Westland case to the latest one of appointment of Lt Gen Bipin Rawat as the next Chief of Army Staff – it has been a rolling saga. A new generation of media (and social media) savvy ex-servicemen have kept the noise levels up on each of the issues at hand.

For a distant, amateur, but interested observer, the ex-servicemen betray a strange sense of entitlement and naivete in their outrage. The over-riding narrative in the COAS appointment saga, for example, is the following:
  • 1.       Govt choosing its own person (instead of going by seniority) increases political meddling in the Army.
  • 2.       Such meddling would result in senior officers currying favours with politicians.
  • 3.       The government is too disconnected from the military to understand merits of individual officers, hence should not get involved.
  • 4.       Rationale like “greater experience in Counter Insurgency operations” (the reported grapevine justifying Gen Rawat’s supersession of the two senior, armoured corps officers) are dubious – each army commander is as good as the other. Selecting an officer on account of greater operational Counter Insurgency experience is unfair, stupid and short-sighted.

5    As a (usual Indian) cul de sac, the example of Pakistan is quoted, where political appointments of the COAS has resulted in horrific consequences, generally.

The narrative is problematic on nearly all grounds.

First, political interference. The issue with the Indian military and politicians is not one of too much interference, but one of too little. For a democracy, the Indian military has an astonishing, somewhat appalling amount of autonomy over policy decisions. On AFSPA for example, successive governments have simply given a veto to the Army on decision-making. The same sense of entitlement and superiority (over "slimy politicians") is sought to be extended to appointments too. In terms of first principles though, it is entirely justified that the political leadership should choose a Chief of its own liking. The buck, finally stops there. The infamy of 1962 in popular narratives doesn’t touch the Indian Army’s massive failings but entirely revolves around the foibles and faux pas of Nehru and Krishna Menon. The responsibility for the nasty surprise in Kargil was laid at the door of Vajpayee’s Lahore diplomacy and civilian intelligence, not the Army (or its initial clumsy response to the threat). If the political leadership is to carry the can, it should darn well have the flexibility to choose any person it deems to be most fit for the Chief's role.

Second, global practice. In this, invocation of the Pakistan example is a red herring (as it is for most things). In both US and UK, the political leadership chooses its own Chief (Chairman, Joint Chiefs and Chief of Defence Staff respectively). There are no precedence, seniority and “arms” limitations binding the government. Taking a look at the latest appointments in both cases in a nutshell.

In January this year in UK, ACM Sir Staurt Peace was appointed the Chief of Defence Staff. It created no great ripples, but this BBC report has some interesting snippets.

          This appointment is a big surprise.
Within the MoD two candidates were being discussed - army general, Sir Richard Barrons, and first sea lord, Admiral George Zambellas.There has been an expectation that the three services would take turns in the job.Given the last two men to hold the job have been army generals, that might have counted against Sir Richard.But the Royal Navy has not had a chief of the defence staff since 2003, and would have felt it was their turn.Admiral Zambellas is certainly seen as charismatic, but that might not be how the prime minister likes his military commanders.Remember David Cameron's quote: "You do the fighting and I'll do the talking."Sir Stuart is his own man - a plain speaker and, like his service, far from stuffy. But he is also a known quantity.He may also be seen as less "partisan" than the other candidates.

In a nutshell, Prime Minister David Cameron selected a candidate who he considered to be “less partisan, less talking”. No one in UK upbraided the PM for using such subjective, behavioral rationale to make a choice, rather than using seniority to decide a first among equals.

In May 2015, President Obama selected Marine General Joseph Dunford as the next Chairman, Joint Chiefs of Staff. There was more news about this, given the Congressional confirmations for such positions in the US. But again, the rationale given for the selection are quite illustrative.
What makes him attractive is that he’s a ground leader, and we’ve still got ground wars going on,” said an administration official, speaking on the condition of anonymity to discuss the selection process.Sen. Jack Reed (R.I.), the ranking Democrat on the Senate Armed Services Committee, said Dunford would be well served by his time in Afghanistan, where he commanded foreign troops, guided a complex U.S. operation and contended with the challenges of local politics. “There are few people that have had the experience he’s had,” Reed said in an interview.

So, extensive counter insurgency and expeditionary experience counted high in the selection. Not dissimilar to the reasons ostensibly given for the selection for Lt Gen Rawat, where his greater operational experience in CI/CT has said to have tilted the scales in his favour. Again, no one raised hackles on why the US President used such rationale while arriving at his choice.

The Indian polity, since 1962 has treated operational military matters with kid gloves, leaving the space completely monopolised by the services. It has had a deleterious impact on India's strategic posture, with a conventional bureaucratic military making shortsighted, regressive calls on facets of national security - induction of indigenous equipment (MBT Arjun being a prime example), force structures (45 sqd air force built around the most expensive aircraft available) and more.

Its time that the political leadership took matters in their own hands. If it starts with the appointment of the new Army Chief, portends good signals!

Sunday, December 18, 2016

Demonetisation - a Schrodinger's cat (banking) success

There isnt enough data out to proclaim if the demonetisation exercise is a success or a failure (though that hasnt prevented even illustrious commentators like Kaushik Basu and Jagdish Bhagwati from weighing in with their views, on either side, on putative outcomes!). Whether this will result in diminution of black money, increase digital penetration, wreck the economy, result in a tax windfall, destroy livelihoods - there's little by way of empirical data, as yet. Some of the high frequency data points (auto sales, rabi sowing area etc) have been mixed, and hence its perhaps too early to conclude one way or another.

However, on one count, ie, that of rescuing the banking sector - as captured in an earlier post, demonetisation is well on its way to achieving its (un)stated objectives. How? Consider the numbers.

Total cash back into the banking system is already ~8 lac crores (12.5 lac crores of old banknotes have been returned, ~4.5 lac crores has been exchanged for new notes). Taking the "worst case scenario" (of the naysayers of the exercise), lets say the entire 15.5 lac crores of old banknotes come back. It would mean banks will be, after accounting for exchange to new notes, left with ~10-11 lac crores of deposits. Given the physical restrictions on withdrawals being likely to be in place for 3-4 months more, it would mean a straight drop of 15-18k crores to bank profits (assuming a conservative NIM of 3% on 11 lac crores for ~5-6 months). Assuming 75% of the deposits flow out once the physical restrictions are waived off, that still means incremental 4 lac crores in deposits, generating 8k crores p.a (@ a modest NIM of 2%) as annuity revenues.

Next, treasury gains to banks as a result of yields dropping and banks booking profits on their G-Sec trading portfolios. As per KV Kamath, the potential treasury gains are as high as 2.5 lac crores this year. Downscaling that number by half would still give 1.25 lac crores. Given the gains displayed by fixed income (and gilt) funds in the market, it provides a reasonable basis for bank treasury portfolio performance.

Last, the general softening of interest rates will result in expansion of margins across the board as legacy deposits are repriced over the next 6-12 months.

Take all the three above together, and the net impact on banks could be expected to be anywhere between 1.3 -1.5 lac crores of additional profits (or capital) for the banking system. The total recapitalisation requirement of Public Sector Banks has been variously estimated to be between 1.8 and 2.5 lac crores by 2019. Whichever number is taken, demonetisation helps plug at least 50% of the requirement. Add in modest government support (current year's budget is 25k crores for recapitalisation), and suddenly banks look to be in a much better shape to raise fresh capital from the market.

Ergo, from data available today, demonetisation as India's TARP is a conclusion that can be reached with reasonable amount of confidence. Certainly much tighter confidence intervals than the broader macro gains (and gloom) being predicted by the commentariat.

Flip side? Unlikely that the government can market this undeniably worthy objective as a measure of its success. In the long run, whatever else demonetisation might end up doing, it would be a Schrodinger's Cat - alive (successful) on the banking side, even if dead (failed) in everything else!

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.