Month: March 2016 | Page 4

16 March, 2016

There Is Only So Much That Rajan Can Do About Interest Rates

The next Reserve Bank of India(RBI) monetary policy meeting is scheduled on April 5, 2016. Given this, calls for the RBI governor, Raghuram Rajan, to cut the repo rate, are already being made. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the short and medium term interest rates in the economy. So the question is will Rajan cut the repo rate or not?

Most economists quoted in the media are of the belief that Rajan will cut the repo rate by 25 basis points. Of course that is the safest prediction to make at any point of time when the repo rate is on its way down. One basis point is one hundredth of a percentage.

I guess I will leave the kite-flying to others and concentrate on other things, which I think are more important than guessing what Rajan will do. The impression given by those demanding an interest rate cut is that the RBI actually determines all kinds of interest rates in the economy. But that isn’t really true.

As Mervyn King, who was the governor of the Bank of England (the British equivalent of RBI), between 2003 and 2013, writes in his new book The End of Alchemy—Money, Banking and the Future of the Global Economy: “We think of interest rates being determined by the Federal Reserve, the Bank of England, the European Central Bank(ECB) and other national central banks. That is certainly true for short-term interest rates, those applying to loans for a period of a month or less. Over slightly longer horizons, market interest rates are largely influenced by the likely actions of central banks.”

The point being that the ability of central banks to influence interest rates, at most points of time, is limited. At best they can influence short and medium term interest rates. As King writes: “But over longer horizons still, such as a decade or more, interest rates are determined by the balance between spending and saving in the world as a whole, and central banks react to these developments when setting short-term official interest rates.”

The word to mark here is “saving”. In the Indian case the household financial savings have fallen over the years. In 2007-2008, the household financial savings had stood at 11.2% of the gross domestic product (GDP). By 2011-2012, they had fallen to 7.4% of GDP. Since then they have risen marginally. In 2014-2015, the household financial savings stood at 7.7% of GDP.

Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.

If interest rates need to fall over the long-term, the household financial savings number needs to go up. And this can only happen if households are encouraged to save by ensuring that a real rate of return is available on their investments. The real rate of return is essentially the rate of return after adjusting for inflation. A major reason why the household financial savings have fallen over the years is because of the high inflation that prevailed between 2007 and 2013.

It needs to be mentioned here that while the household financial savings have fallen over the years, the private corporate financial savings (basically retained profits of companies) have gone up over the years. In 2007-2008, the private corporate savings had stood at 8.7% of the GDP. In 2014-2015, they stood at 12.7% of the GDP. So, a fall in household financial savings has more than been made up for, by an increase in corporate financial savings.

The trouble is that corporates do not like to lend long term in the financial system. Most of the private corporate savings are invested in short term bonds and mutual funds which in turn invest in short-term bonds. Hence, corporate savings are typically unavailable for long-term borrowers. They need to depend on household financial savings.

Hence, it is important that household financial savings keep increasing in the years to come. Low interest rates are not possible otherwise.

Also, it needs to be mentioned here that the borrowing by state governments has gone up dramatically over the last few years. In 2007-2008, the state governments borrowed Rs 68,529 crore. This number has since then gone up 3.5 times and in 2014-2015 had stood at Rs 2,38,492 crore. A report in the Mint newspaper expects borrowings by state governments to touch Rs 3,00,000 crore in 2015-2016, a jump of more than one-fourth over the borrowing in 2014-2015.

The borrowing by state governments is expected to remain high in the years to come. This is primarily because of the UDAY scheme that the central government has launched to sort out the mess in the power distribution companies all across the country.

Hence, the demand for money which can be invested over the long-term has gone up over the years and is expected to continue to remain high. In this scenario, the supply of money, through household financial savings needs to improve.

If the number does not improve then the interest rate scenario is unlikely to improve irrespective of the RBI pushing the repo rate down. And the number can only improve if savers get a real rate of return on their investment, encouraging people to save more. This has started to happen only over the last two years.

Rajan has often said in the past that he wants to maintain a real interest rate level of 1.5-2%. Real interest is essentially the difference between the rate of interest (in this case the repo rate) and the rate of inflation.

The consumer price inflation on which the RBI bases its monetary policy on, in February 2016, stood at 5.2%. If we to add 1.5% to this, we get 6.7%, which is more or less similar to the prevailing repo rate. The current repo rate stands at 6.75%. Hence, Rajan’s formula is clearly at work.

To conclude, it is worth remembering something that George Gilder wrote in Knowledge and Power: “The fastest growing economies in the world have been heavy savers. Saving powerfully diverts consumption preferences from immediate goods to the array of intermediaries funded by savings. Savings prepare the economy for a long future of growth, compensating for the dwindling harvests of consumption in a world of impetuous spending.”

This is something the rate cut crowd needs to understand.

The column originally appeared on Vivek Kaul’s Diary on March 16, 2016

15 March, 2016

Mr Jaitley, the New Black Money Scheme is Nothing but an Amnesty Scheme

In the budget speech finance minister Arun Jaitley made on February 29, 2016, he proposed: “a limited period Compliance Window for domestic taxpayers to declare undisclosed income or income represented in the form of any asset and clear up their past tax transgressions by paying tax at 30%, and surcharge at 7.5% and penalty at 7.5%, which is a total of 45% of the undisclosed income.”

So, if you have black money, and are willing to pay 15% extra to the government, over and above the top tax rate, the laws of the land won’t apply to you. As Jaitley further said in his speech: “There will be no scrutiny or enquiry regarding income declared in these declarations under the Income Tax Act or the Wealth Tax Act and the declarants will have immunity from prosecution. Immunity from Benami Transaction (Prohibition) Act, 1988 is also proposed subject to certain conditions.”

In an interview to the national broadcaster Doordarshan, Jailtey later said: “It’s not a VDIS (Voluntary Disclosure of Income Scheme) and it is not an amnesty.” Like a good lawyer, he did not specify what the scheme really is.

So what does the word amnesty mean? I looked for and managed to find my fifteen-year-old The Compact Oxford Reference Dictionary. The dictionary lists out two meanings for the word amnesty. Here are the two meanings: a) an official pardon for people convicted of political offences. b) a period during which people admitting to particular offences are not prosecuted (the italics are mine).

As Jaitley said during his budget speech: “We plan to open the window under this Income Disclosure Scheme from 1st June to 30th September, 2016 with an option to pay amount due within two months of declaration.”

Hence, anyone admitting to having black money during this period and paying the tax, the surcharge and penalty on it, will not be prosecuted under the laws of the land and will have immunity. This is precisely the Oxford Reference Dictionary’s meaning for amnesty – a period during which people admitting to particular offences are not prosecuted.

So, even if Mr Jaitley does not want to call the government’s black money amnesty scheme, an amnesty scheme, it is nothing but an amnesty scheme. If you are willing to declare your black money, pay 30% tax and 15% extra on it, the law of the land will not apply on you.

Now compare this to advance tax which needs to be paid by the non-salaried income tax payers several times during the course of a year. As per Section 234C of the Income Tax Act, if advance tax is not paid on time, a fine of 1% per month needs to be paid on the total amount of tax outstanding. Hence, the government is basically treating everyone who has black money and has not paid tax on it, a little worse than someone who has not paid advance tax for a year.

Also, it is interesting that this time around the government wants those who have black money to pay only 15% extra and get immunity. In May 2015, the Parliament had passed the Undisclosed Foreign Income and Assets (Imposition of New Tax) Act. After the passage of this Act, the government offered a compliance window.

This window allowed those with undisclosed foreign assets and income(or foreign black money) to declare them, pay a tax of 30% and a penalty of 30%. The window was closed on September 30, 2015.

Taking advantage of the compliance window 638 declarants declared assets and income of Rs 4,147 crore in total. This meant that the government was able to collect around Rs 2,488 crore (60% of Rs 4,147 crore) as tax revenues.

For all the hype and hoopla that happened, the actual collection was basically very small. Did this failure lead to the government just asking for 15% extra this time around, instead of 30%, as was the case last year?

Further, is there a distinction being made between foreign black money and domestic black money? The domestic black money stays within the country and has some utility. It is spent on consumer goods and real estate. Hence, the money enters the domestic financial system and is income for many individuals.

So, even though tax is not paid on this money, it does have its utility. The same cannot be said about black money that has left the country. And is that why the government is handling those declaring black money in the next financial year, with kids gloves?

The one good thing that Jaitley has done is that he has not assumed the total amount of money he expects the government to earn through the black money amnesty scheme, as a part of the government income for the next financial year.

Guess there is no way to possibly estimate this. The last time the government launched such a scheme was in 1997. The scheme ran between July 1, 1997 and December 31, 1997. The scheme allowed individuals with black money to come out in the open and pay a tax of 30% on their black money. In case of others i.e. corporates and firms, a tax of 35% had to paid.

The government ended up collecting Rs 9,584 crore from around 4.75 lakh declarants. Nevertheless, the scheme was different from the one that will be launched in June this year, given that back then the black money wallahs did not have to pay any fine. This time around there is a 15% fine. Also, the response to the amnesty scheme on foreign black money launched last year, had had a thanda response.

Given these ifs and buts, it’s a good thing that the government has not made any assumptions about the total amount of money they expect to earn through this route. But this hasn’t stopped the stock market wallahs from trying to come up with a number.

Akash Prakash of Amansa Capital expects the government to earn Rs 50,000 crore through this route. He doesn’t explain how he came up with the number. The thing is that the government hasn’t gotten around to putting a number to the money it expects to earn is primarily because there is no way a reasonable estimate can be made.

In that scenario how did Mr Prakash come up with a Rs 50,000 crore number? Or like other fund managers was he just being optimistic for the sake of being optimistic? That as we know is a favourite pastime of the fund managers.

The column originally appeared on Vivek Kaul’s Diary on March 15, 2016

14 March, 2016

Cash Transfer of Subsidies is the Right Way Forward

In his book Naked Economics—Undressing the Dismal Science, the American author Charles Wheelan recounts a very interesting story about his visit to Cuba. Cuba, as you know, dear reader, has been under a communist regime for a very long time.

As Wheelan writes: “Because the visit was licensed by the U.S. government, each member of the delegation was allowed to bring back $100 worth of Cuban merchandise, including cigars. Having been raised in the era of discount stores, we all set out looking for the best price on Cohibas [a premium Cigar brand] so that we could get the most bang for our $100 allowance. After several fruitless hours, we discovered the whole point of communism: The price of cigar was the same everywhere. There is no competition between stores because there is no profit as we know it. Every store sells cigars—and everything else for that matter—at whatever price Fidel Castro (or his brother Raul) tells them to.”

Wheelan had basically experienced in Cuba what we in India call the public distribution system. Further, he had managed to find cigars everywhere he went though at the same price. What this tells us is that the public distribution system in Cuba did work, at least when it came to cigars. In India, it does not.

The government runs the public distribution system through around five lakh fair priced shops also known as ration shops. Unlike Cuba, these shops are very leaky. And food grains and kerosene that are sold through these shops do not reach the intended beneficiaries and find its way into the open market. The fair price shop owners benefit in this process.

As per the Economic Survey which was released last month, 54% of the wheat and 15% of the rice that is distributed through the public distribution system does not reach the intended beneficiaries. Along similar lines, 48% of sugar is siphoned off as well (as per last financial year’s Economic Survey). When it comes to kerosene, nearly 46% is siphoned off. 24% of domestic cooking gas and 40% of fertilizer is also siphoned off.

This means that the government of India loses a lot of money every year. As the economist Kaushik Das writes in An Economist in the Real World: “The problem arises from the fact that in India the food subsidy is handed to poor households via the ration shops. The government delivers subsidised grain to the store owner and the owner is then instructed to hand this over at the prescribed price to Below Poverty Line (BPL) households and to some other categories of vulnerable households.”

The assumption is that the shop owners will honestly pass on the grains and kerosene to those it’s meant for. As Basu writes: “If store owners were perfectly honest, this would work fine. But if they are not, then it is easy to see that many of them will give in to the temptation of making some easy money by selling off some of this subsidised grain in the open market where the price is higher, and turning away some of the deserving poor households or adulterating the grain that is to be sold to those households…A large share of the wheat meant to reach the poor never does because it is pilfered or sold on the open market en route.”

So what is the way out of this? One way is better policing. Nevertheless, as Basu writes: “It is easy to respond to this by asking for better policing. But we have to be realistic. Trying to police such a large system by creating another layer of police and bureaucracy will come with its own problems of corruption and bureaucracy.”

A better solution for this mess is to handover the subsidy directly to the poor households instead of going through the fair price shop owner. How can this be done? This can be carried out through the Aadhaar card linked to a savings bank account.

The penetration of Aadhaar cards has gone up at a very rapid pace all across India. As the Economic Survey points out: “The current government has built on the previous government’s support for the Aadhaar program: 210 million Aadhaar cards were created in 2015, at an astonishing rate of over 4 million cards per week. 975 million individuals now hold an Aadhaar card – over 75 percent of the population and nearly 95 per cent of the adult population…Aadhaar penetration is high across states. Nearly one-third of all states have coverage rates greater than 90 percent; and only in 4 states—Nagaland (48.9), Mizoram (38.0), Meghalaya (2.9) and Assam (2.4)—is penetration less than 50 per cent.”

These cards now need to be linked to savings bank accounts. This will ensure that instead of handing over subsidised grains to the intended beneficiary through the fair price shop route, the government can simply transfer money into his Aadhaar linked bank account. This money can then be used to buy the food grains from any shop instead of just the shops which come under the public distribution system.

This will create competition among shops and ensure that the poor get access to the food grains that they are entitled to. It will also ensure that the leakage of food grains will come down dramatically.

As the Economic Survey points out: “After identifying beneficiaries, the government must transfer money to them. Every beneficiary needs a bank account and the government needs their account numbers. This constraint has been significantly eased by the Pradhan Mantri Jan Dhan Yojana, under whose auspices nearly 120 million accounts were created in the last year alone—at a blistering, record-setting pace of over 3 lakh accounts per day.”

The trouble is that despite this blistering pace, the savings account penetration continues to remain low across large parts of the country. As the Economic Survey points out: “Despite Jan Dhan’s record-breaking feats, basic savings account penetration in most states is still relatively low – 46 per cent on average and above 75 per cent in only 2 states (Madhya Pradesh and Chattisgarh).”

The sooner this is corrected, the faster the government can move to putting cash directly in the accounts of people instead of trying to distribute food grains through a leaky public distribution system.

To conclude, on March 11, 2016, the government moved one step closer to cash transfer of subsidies. The Lok Sabha passed the Aadhaar Bill. Given that the Bill was introduced as a money bill, the government doesn’t have to get the Bill passed through Rajya Sabha.

The column originally appeared on Vivek Kaul’s Diary on March 14, 2016

11 March, 2016

The Fallacy of Composition: Selling Equity, Buying Gold

Gold has done well in the recent past. Over the last six months it has given a return of around 14% (in dollar terms) and is currently quoting at $1250 per ounce (one troy ounce equals 31.1 grams). With these returns gold is coming back on the investment radar, though over the last five years the yellow metal has given a negative return of 12%.

Indians have always been fascinated with the idea of buying gold. As per the World Gold Council the consumer demand for gold in 2015 stood at 848.9 tonnes. Of this 654.3 tonnes was gold that went towards making jewellery and 194.6 tonnes was gold that went towards making bars and coins.

Interestingly, India now lags behind China when it comes to gold consumption. In 2015, Chinese consumer demand for gold stood at 984.5 tonnes, around 16% more than Indian demand. The Chinese consumed more gold than India both when it comes to jewellery as well as gold in the form of bars and coins.

The trouble in the Indian case is that the country produces very little gold of its own. In 2015, the domestic supply of gold in India, as per estimates made by the World Gold Council stood at 9.2 tonnes or a little over 1% of total consumer demand. This supply came from local mine production, recovery from imported copper concentrates and disinvestment.

What this means is that India imports a bulk of its gold demand. As Akhilesh Tilotia of Kotak Institutional Equities who is also the author of The Making of India writes in a recent research note titled Selling Equity for Gold: “On net basis, i.e. accounting for the gold which is imported for re-export, Indians bought US$267 billion of gold over the past decade.”

The gold that is imported into India needs to be paid for in dollars. India’s stock of dollars comes in from various things including foreign direct investment(FDI) made into companies and projects and foreign portfolio investment(FPI) made into stocks and bonds.

As Tilotia writes: “According to our calculations, FPIs own a quarter of the outstanding stock of the BSE-200 stocks as of 2QFY16. Over the past decade, India received net equity FII flows of US$119 bn; the net FDI inflow is US$185 billion.”

If we add the FPI and FDI numbers for the last decade it comes to $304 billion. As mentioned earlier India net-imported gold worth $267 billion over the last decade. This essentially means that a bulk of the dollars that came into India through the FDI and the FPI route where used to buy up gold.

As Tilotia writes: “Indians have, over the last decade, traded equity in their private and public companies for gold. Of the US$304 billion that came in as net FDI and FII inflows over the last decade (FY2007-16E), Indians bought gold worth US$267 billion.”

To put it simply, over the years, India has sold stocks to earn dollars and in turn used these dollars to buy gold. While this wasn’t planned, this is how things have turned out. In the process, the country has become a victim of the fallacy of composition.

As Greg IP writes Foolproof—Why Safety Can Be Dangerous and How Danger Makes Us Safe: “This fallacy occurs when what benefits an individual is wrongly assumed to benefit an entire group. For example, if one moviegoer stands, he can see the show better. But if everyone in the audience stands, no one sees better, and everyone is uncomfortable.”

Indians buying gold is a tad like that. When an individual Indian buys gold either as jewellery or as an investment or as a hedge against inflation, it makes sense for him at individual level. But when the same thing happens at a societal level, it creates problems for the country.

Buying gold needs dollars, which can’t be created out of thin air. Further, it can also lead to the value of the rupee against the dollar falling as had happened between May and August 2013, when the dollars coming into India dried up, but Indians still continued to buy gold. As Tilotia writes: “when foreign fund flows dried up, Indians continued to buy gold thereby precipitating worries of large slippages on the current account deficit.”

It also led to the demand for dollars going up leading to the rupee depreciating against the dollar. This led to the value one dollar nearly touching Rs 70. This became a huge problem given that oil imports suddenly became very expensive as Indian oil marketing companies had to pay more in rupees in order to buy dollars they required to buy oil. The demand of oil companies for dollars led to further depreciation of the rupee against the dollar.

Further, these were the days when diesel was subsidised by the government. The government in turn compensated the oil marketing companies for the under-recoveries they occurred. This pushed up the government expenditure as well as the fiscal deficit. The fiscal deficit is the difference between what a government earns and what it spends.

Of course, every time someone buys gold, it takes away money from another productive investment. Gold essentially is useful because it is useless.

All this was an impact of the fallacy of composition which came with Indians buying gold. The government is now trying to address this fascination that we have for gold through the gold monetisation scheme and the sovereign gold bonds. Let’s see how successful they are with it.

The column originally appeared on Vivek Kaul’s Diary on March 11, 2016

10 March, 2016

Why Public Sector Companies Have Made Losses of More Than Rs 1 Lakh Crore

Buried in the inside pages of the Economic Survey of 2015-2016 released on February 26, 2016, is a very interesting data point.

The accumulated losses of sick public sector enterprises as of March 31, 2014, stood at Rs 1.04 lakh crore. This essentially means that the government of India has pumped a lot of money into these companies over the years to keep them going.

The Survey does not point out whether the accumulated loss number of Rs 1.04 lakh crore takes the time value of money into account. What is the time value of money? Let’s say 10 years back the public sector enterprises made a loss of Rs 2,000 crore. The government took on this loss and compensated them for it. The value of the Rs 2000 crore the government handed over to these loss making enterprises, ten years later, would be much greater than Rs 2,000 crore. (This example is for illustrative purpose only).

My guess is that the loss number of Rs 1.04 lakh crore does not take the time value of money into account. If it had, the loss number would have been much higher. The question is why have the public sector enterprises lost so much money over the years?

Charles Wheelan has the answer in Naked Economics—Undressing the Dismal Science. He gives the example of Hindustan Fertilizer Corporation. As he writes: “By 1991, the Hindustan Fertilizer Corporation had been up and running for twelve years. Every day, twelve hundred employees reported to work with the avowed goal of producing fertilizer. There was just one small complication. The plant had never actually produced any saleable fertilizer. None. Government bureaucrats ran the plant using public funds; the machinery that was installed never worked properly.”

Further, the workers came in every day and the government kept paying their salaries. As Wheelan writes: “The entire enterprise was an industrial charade. It limped along because there was no mechanism to force it to shut down. When the government is bankrolling the business, there is no need to produce something and then sell it for more than what it cost to make.”

If the government keeps making up for the losses of any company, what incentive do the management and the employees have to turn it around? None. A good comparison here are the public sector banks, in which the government has infused Rs 1.02 lakh crore of capital between 2009 and September 2015.

There is another point that needs to be made here. Up until the 1990s when the government ran most businesses in the country, the smartest lot either left the country or worked for the government.

As the economy opened up 1991 onwards, people started looking at other options as the number of jobs offered by the private sector in sectors as diverse as banking to telecom, exploded. The private sector also offered extra incentives to their best performers. The government meanwhile continued follow a uniform pay scale.

As Wheelan writes: “This uniform pay scale creates a set of incentives the economists refer to as adverse selection.” What does the term mean in this context? The most talented professionals who earlier worked for the government now had the option for working for the private sector where there pay was closely linked to their productivity unlike the government.

On the flip side, as Wheelan puts it “for the least talented, the incentives are just the opposite.” They know that working for the government would mean a fixed salary and regular increments over the years, which will not ‘really’ depend on their performance. Hence, those who have ended up working for the government over the last couple of decades where definitely not the best of the lot.

The fact that the government has been ready to bailout the loss making public sector enterprises and the best people don’t work for it anymore, has led to a situation where the losses have just kept piling up.

In sectors where the private sector has been allowed entry it has flourished and the government companies have had to take a backseat. As the Economic Survey points out: “The Indian aviation and telecommunication sectors of today are unrecognizably different from what they were 20 years ago, with enormous benefits for the citizens. Public sector companies now account for a small share of the overall size of these sectors.”

Despite, the public sector enterprises being a small insignificant part of many sectors and with many of these companies making losses, the government continues to operate them and take on their losses. A major reason remains the fear of taking on the trade unions.

In fact, many of these loss making companies own large tracts of land and can be a huge revenue spinner for the government. As the Economic Survey points out: “Most public sector firms occupy relatively large tracts of land in desirable locations. Parts of this land can be converted into land banks and made into vehicles for promoting the ‘Make in India’ and Smart City campaigns. If the land is in dense urban areas, it could be used to develop eco-systems to nurture start-ups and if located in smaller towns and cities, it could be used to develop sites for industrial clusters.”

I hope the government shuts down these loss making companies and starts selling the large tracts of land that they own.

Postscript: In a major embarrassment to the Modi government, the opposition parties got an amendment passed to the President’s most recent address to the Parliament. How is this significant? In yesterday’s column I had discussed how the Modi government continues to be precariously placed in the Rajya Sabha. And given this I don’t see it getting the Goods and Services Tax Bill passed through the Rajya Sabha.

Morgan Stanley in a recent research note had claimed otherwise. They had said by July 2016, the BJP led NDA government should be in a position to get the GST Bill passed. Nevertheless, the point is that if the government cannot get even the President’s address passed through the Rajya Sabha without an amendment, where is the question of it getting the GST Bill passed? Maybe Morgan Stanley can possibly explain that to us.

The column originally appeared in the Vivek Kaul Diary on March 10, 2016