Gujarat Elections: In 2018 and 2019, with More Socialism, Modi Will Become More Like Manmohan

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As expected the Bhartiya Janata Party (BJP), won the state assembly elections in Gujarat. The margin of victory though left much to be desired.

Before the elections, the party president Amit Shah had talked about the party winning 150 out of the 182 seats in the state assembly. The party finally ended up with 99. So, there was a clear gap between expectation and reality. I say this because Amit Shah is a brilliant electoral strategist and his words should never be taken lightly.

Finally, it is the massive support that the BJP enjoys in the cities of Gujarat that pushed it through. In the four biggest cities of Gujarat, Ahmedabad, Surat, Vadodara and Rajkot, the party won 46 out of the 55 seats (Ahmedabad 16 out of 21 seats, Surat 15 out of 16 seats, Vadodara nine out of 10 seats and Rajkot six out of eight seats).

What this clearly tells us is that the Goods and Services Tax (GST) wasn’t as big an issue in the cities of Gujarat, as was made out to be in the days leading up to the elections, in the media. It clearly impacted a section of the population, but that wasn’t large enough to make an electoral difference. The only other explanation for this lies in the fact that even those impacted negatively by the GST, couldn’t get themselves to vote for the Congress.

The other interesting point here was that more than 5.5 lakh voters chose the NOTA (none of the above) option while voting. This amounted to 1.8 per cent of the total eligible votes. The NOTA votes were more than or close to the winning margins in nearly 24 constituencies. One explanation for this that has been offered is that a small section of the population which is unhappy with the BJP didn’t want to vote for Congress either.

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The trouble with this explanation is that there is no way to verify it. It could even be the opposite.

Anyway, getting back to the point I was trying to make—the BJP won 46 out of the 55 seats in the four biggest cities of Gujarat. How did the electoral results look in the remaining 127 seats? The BJP won 53 of these seats. The Congress won 71. Hence, the Congress clearly did much better than the BJP beyond the four biggest cities.

There will be economic and political implications of these electoral results in other states like Rajasthan and Madhya Pradesh, where the elections are scheduled in the months to come. Some points are as follows:

a) The basic problems in India’s rural economy are not going to go away any time soon. The size of the average agricultural holdings in India has fallen as land has been divided across generations, making agriculture as a profession very non-remunerative.
Over and above this, India has too many people in agriculture than is economically feasible. A recent discussion paper by Niti Aayog points out that as of 2011-2012, agriculture employed 64 per cent of the rural workforce but produced only 39 per cent of the total rural economic output. Hence, for agriculture to be economically feasible 8.4 crore agricultural workers need to be shifted out of agriculture. This is around 70 per cent of the non-farm workforce in the rural areas. This isn’t going to happen overnight.

b) Of course, given this huge disguised unemployment in agriculture, people working in agriculture try to work in other areas as well. But the trouble is that there aren’t enough jobs going around for them. Data from the Labour Bureau suggests that only 52.7 per cent of the people looking for jobs all through the year, in rural India, are able to find one. Given this, nearly one in two people in rural India do not have jobs all through the year.

Hence, rural India has a problem at two levels: 1) Agriculture as a profession is no longer as remunerative as it used to be. 2) There are not enough other jobs, given their low skillsets, which people working in agriculture can take on, to add to their income over and above what they make in agriculture.

This explains why land-owning castes have been protesting all across the country. This includes the Patidar Patels of Gujarat.

c) Given this, the BJP in every state that it goes to election after Gujarat, it is likely to promise a farm loan waiver, as it has done in other states over the last one year. This is going to cost state governments all across the country a lot of money. It will also create moral hazard with future borrowers waiting for farm loan waivers than paying off their loans.

The question is why did the BJP not promise a farm loan waiver in Gujarat? The rural areas in Gujarat are not as badly placed as in other states. One reason for this lies in the fact that the livestock economy in the state, has continued to grow robustly. Also, over and above this, the non-farm economy in the rural areas, created job opportunities because of the overall faster growth in the state.

In fact, farm loan waive offs will become even more important given that, the states of Madhya Pradesh and Rajasthan, are not as urbanised as Gujarat is.

Also, in the run up to 2019 Lok Sabha elections, I see the minimum support price of agricultural crops going up. As per the Shanta Kumar Committee, the minimum support price system benefits under 6 per cent of the farming households in the country. While, increasing MSPs may not benefit many farmers, it does have a strong signalling effect.

d) The Modi government will also look to consolidate its position in the urban and semi-urban areas. And for that, chances are it will waive off Mudra loans of Rs 50,000 or lower. In total, over 7 crore of Mudra loans of less than Rs 50,000 have been given out.

e) As far as the Congress is concerned, it needs to start rebuilding itself, particularly in the rural areas because that is where its support is. This is a rather obvious insight.
To, conclude, the Modi government will give out doles and waive off loans, in order to improve its position. This strategy will not be much different from what the Congress led UPA government led by Manmohan Singh, did in the 2009 elections. This again goes with the broader point that I keep making—India has only one model of governance and that is the Congress model.

In the end, socialism will win. We will have a bigger government in areas that we really shouldn’t.

The column was originally published in Equitymaster on December 19, 2017.

Who is Benefitting from Lower Interest Rates?

 

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Over the last one year, bank interest rates have fallen majorly, at least in theory (it will become clear later in the column, why I say this). The question is, who is benefitting from the lower interest rates? The savers, whose fixed deposits have matured, have had to reinvest them at significantly lower interest rates. This includes retirees who have seen interest rates on their deposits, fall from nine per cent to six per cent in a short period of time. In the process, their incomes have crashed by a third. Not surprisingly, they are having a tough time.

People have suggested that senior citizens should invest with the post office where higher interest rates are on offer. Anyone who has actually invested money with the post office for generating a regular income, would never suggest anything like this. Their service levels are abysmally low. They can give a thorough run around to anyone looking to get paid regularly on the investment he has made with the post office.

In fact, I know of several retirees who have reluctantly moved their investments into mutual funds (both equity and debt), given the low after-tax returns on fixed deposits. Even if the returns on mutual funds are the same as bank fixed deposits, the different tax treatment for both these forms of investing, helps generate higher after-tax returns in case of mutual funds.

This investing strategy has worked well for retirees in the last one year, given that the stock market has rallied massively. Nevertheless, is this a sustainable strategy in the long-term for anyone who is looking to generate a regular income out of his accumulated corpus, given the volatility that comes with investing in a mutual fund?

In a country with almost no social security and a health care system which keeps getting expensive by the day, this is a fair question to ask.

Another set of savers who has lost out due to low interest rates are people saving for their future, the wedding and education of their kids, and their own retirement. These people now need to save more in order to meet their long-term investment goals. Of course, these people still have the option of discovering the power of compounding by investing in mutual funds through the systematic investment plan (SIP) route.

But given the abysmal levels of financial literacy that prevail in the country, the chances that they will be mis-sold a unit linked insurance plan(ULIP) by a private insurance company or an endowment or a money-back policy by Life Insurance Corporation of India, remain very high. These forms of investing remain the worst way you can invest your money.

Also, consumption growth and interest rates are closely linked. Conventional economic logic tells us that at lower interest rates people borrow and spend more, and this increases private consumption growth and in turn helps economic growth. QED.

While that may be true for developed countries, it doesn’t quite work like that in India. In India, if interest rates fall, the retirees need to cut down on their regular expenditure because their regular income also falls. People who are saving for the long-term also need to save more in order to meet their investment goals.

Given that most household financial savings get invested in fixed deposits, a fall in interest rates makes people feel less wealthy and this has an impact on their consumption. Due to these reasons people end up cutting down on their expenditure. This is reflected to some extent in Figure 1, which plots the growth in private consumption expenditure over the last few years.

Figure 1: 

As interest rates have fallen through 2017, the growth in private consumption expenditure has collapsed from 11.1 per cent to 6.5 per cent. As of December 2016, private consumption expenditure formed 59 per cent of the Indian gross domestic product. Since then, it has fallen to 54 per cent. So, much for lower interest rates.

There are two sides to interest rates, the saving side which I was talking about up until now, and the borrowing side, which I will talk about in the remaining part of this column.

The total non-food lending carried out by Indian banks has actually contracted during this financial year. But weren’t lower interest rates supposed to help increase lending? Now only if economic theory and reality played out same to same, the world would be such a different place.

Banks are extremely quick to cut interest rates on their fixed deposits, as well as raising interest rates on their loans. Nevertheless, the same cannot be said about a situation where they need to pass on the benefit of lower interest rates to their borrowers.

Let’s take the example of people who have taken on home loans from banks as well as housing finance companies. Over the last one year, the interest rate on a home loan has fallen from 80 to 100 basis points. One basis point is one-hundredth of a percentage.

The trouble is in many cases the banks and the housing finance companies haven’t bothered to inform the borrower, about the lower interest rate. And the borrower has unknowingly continued to pay the higher EMI. This never happens when the banks and the housing finance companies need to raise interest rates on their home loans. In that case, the letter/sms/email arrives right on time.

In fact, I have heard cases where people have pointed this dichotomy out to a leading housing finance company, and they have been told that they are expected to come to the office of the housing finance company and keep checking. So much for market competition which is supposed to lower interest rates. Of course, the stock market rewards such companies with a higher price to earnings ratio, given that they can do these things, get away with it, and make more money in the process.

The media which is quick to announce lower EMIs whenever RBI cuts the repo rate, never goes back to check whether EMIs have actually fallen. This is simply because it is easier to take the theoretical way out and announce lower EMIs when RBI cuts the repo rate, whereas actual checking would involve doing some legwork and speaking to banks, housing finance companies and borrowers. And who wants to work hard? It’s worth pointing out here that banks are huge advertisers in the media.

The question is when higher interest rates are passed on immediately, why is the same not true with lower home loan interest rates? What are the Reserve Bank of India (RBI) and the National Housing Bank (the RBI subsidiary which regulates housing finance companies) doing about this? Aren’t the regulators also supposed to take care of the consumers? Or are they just there to bat for those who they regulate? Or is it a case of “regulatory capture” where those who are regulated (i.e. the banks and the housing finance companies) given that they are organised, manage to get their point of view to the regulator, but the borrowers, given that they are not organised, cannot do that.

Whatever it is, it is not fair. And the RBI and the National Housing Bank need to do something about it. Consumer protection is something that should be high on their agenda, even though it may be the most unglamorous of things that they are supposed to do.

The column originally appeared in Equitymaster on December 14, 2017.

India Has 8.4 Crore More Workers in Agriculture Than is Economically Feasible

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One of the themes that I have often explored in my columns and discuss in detail in my book India’s Big Government, is that India has way too many people working in agriculture. Or as economists like to put it, we have huge disguised unemployment in agriculture.

A new discussion paper titled Changing Structure of Rural Economy of India Implications for Employment and Growth, authored by Ramesh Chand, SK Srivastava and Jaspal Singh, and published by the NITI Aayog, makes a few interesting points on this front.

As per this discussion paper, the rural economy in 2011-2012, formed 46.9 per cent of India’s economy, though it employed 70.9 per cent of its workforce.

Most people tend to believe that India’s rural economy is primarily concerned only with agriculture. Agriculture contributes around 12-13 per cent of the overall Indian economy.

Given that, the rural economy contributes 46.9 per cent to the overall Indian economy, it basically means that there are other areas that the rural economy is contributing to as well. And some of the findings of this discussion paper may surprise many people. Let’s look at them one by one.

1) One of the misconceptions that prevails is that rural India is totally dependent on agriculture. The discussion paper sets this right. As it points out: “Contrary to the common perception about predominance of agriculture in rural economy, about two third of rural income is now generated in non-agricultural activities.” This was clearly not the case earlier.

2) This is primarily because agriculture as a profession is nowhere as rewarding as it used to be. As the discussion paper points out: “In year 2011-12 per worker income varied from Rs. 33,937 for agricultural labour to Rs.1,71,836 for rural non-farm workers.” The ratio of rural non-farm rural income to income of agricultural labour has increased over the years, though it has fallen in the recent past.

Take a look at Figure 1. It plots the ratio of non-farm rural income to income of agricultural labour over the decades.

Figure 1: 

Take a look at Figure 2. It plots the ratio of average urban income to that of average income of an agricultural labour.

Figure 2: 

Figure 2 clearly explains why people migrate from rural areas to urban areas. As the discussion paper clearly points out: “Between 2001 and 2011, India’s urban population increased by 31.8 per cent as compared to 12.18 per cent increase in the rural population.

Over fifty per cent of the increase in urban population during this period was attributed to the rural-urban migration and re-classification of rural settlements into urban.” There is a clear economic incentive for people to move from rural areas to urban areas.

3) With two-thirds of rural income now being generated from non-agriculture activities, the rural economy as a whole when it comes to income is moving away from agriculture, but that is not true when it comes to employment. This is something that I have been talking about for a while. Indian agriculture employs way too many people in comparison to what it needs.

The discussion paper points out that in 1970-1971, agriculture formed 72.4 per cent of India’s rural economy, and employed 85.5 per cent of the rural workforce. By 2011-2012, the size of agriculture had nearly halved, and it formed 39.2 per cent of India’s rural economy, but it still employed 64.1 per cent of the rural workforce. This data points shows that agriculture continues to employ many more people than it should.

4) Having said that, there is another point that needs to be made here. While, the overall employment in agriculture given its share in the rural economy remains high, it has fallen dramatically between 2004-2005 and 2011-2012. In 2004-2005, agriculture formed 38.9 per cent of India’s rural economy, while employing 72.6 per cent of the country’s rural workforce. By 2011-2012, agriculture formed 39.2 per cent of India’s rural economy, and at the same time employed 64.1 per cent of the rural workforce.

Hence, there has been a fall in the total number of people dependent on agriculture. But is this goods news?

5) As the discussion paper points out: “Sizable occupational shifts in workforce were also observed between 2004-05 and 2011-12. Out of 33 million workers who left agriculture 27 million (81%) were female and 6 million (19%) were male. Further, outgoing workforce from agriculture comprised both cultivators and agricultural labours with their respective shares of 56 per cent and 44 per cent. It is worth mentioning that out of 27 million female workers who left agriculture, only 5 million joined non-farm sectors and rest withdrew from labour-force itself.”

So, the point is that while lesser proportion of the workforce is now dependent on agriculture than was the case in the past, many of the women who have dropped out of agriculture, have stopped working all together. Indeed, this de-feminisation of the workforce, is a very disturbing trend.

6) The takeaway from the NITI Aayog discussion paper is that in 2011-2012, agriculture employed 64 per cent of the rural workforce and produced only around 39 per cent of its economic output. In an ideal world, a sector producing 39 per cent of output, should employ 39 per cent of the workforce.

For something like this to happen, nearly 8.4 crore agricultural workers need to be shifted to sectors other than agriculture. As the discussion paper points out: “This amounted to almost 70 per cent increase in non-farm employment, which looks quite challenging.” It also amounts to around one-fourth of the rural workforce of 34.2 crore as of 2011-2012. Chances are the 8.4 crore number would have grown between 2011-2012 and now.

Over and above this, the bigger challenge is the agriculture workforce lacks skills to do anything else. As per the discussion paper: “Only 1.3 per cent of the rural workforce of the age group 15-59 years possessed technical education. Similarly, only 14.6 per cent of the rural workforce of age group 15-59 years received vocational trainings, which aim to develop competencies (knowledge, skills and attitude) of skilled or semi-skilled workers in various trades.”

These skills cannot be improved overnight and jobs be created. Hence, the fear is that the current generation of Indians still largely dependent on agriculture, are going to lose out in the process. As time goes by, this looks more and more likely.

7) One area which has added to employment is construction. Construction formed 3.5 per cent of the rural economy in 1970-1971. This increased to 10.5 per cent by 2011-2012. The share of the sector in rural employment in 1972-1973 was at 1.4 per cent. This jumped to 10.7 per cent in 2011-2012.

One area where agricultural workers can be nudged towards is construction. As the discussion paper points out: “Rural areas are characterised by poor infrastructure and civic amenities. Similarly, a large per cent of houses are in need of upgradation. These facts indicate considerable scope for growth of construction sector in rural areas.”

Over and above this, the real estate sector in urban areas can be a huge employment generator. But for that to happen, the prices need to fall, and more than a few real estate companies need to go bust.

While the role of the government in India to be able to achieve anything significant is limited, this is something where both the state governments and the central government, can have a major role to play. Road construction is one area where many jobs can be generated. This can then act as a multiplier for the services sector as well. As people earn more they are likely to spend more.

To conclude, the fact that India has way too many people employed in agriculture, is probably the country’s biggest social and economic challenge. The trouble is no one really is even talking about it, let alone working towards a solution. The first step towards solving any problem is acknowledging that it exists.

The column originally appeared in Equitymaster on Dec 13, 2017.

Using Deposits to Rescue Banks is a Bad Idea; It Needs to Be Nipped in the Bud

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I have been travelling for the past two weeks and a question that has been put to me, everywhere I have gone is: “will fixed deposits be used to rescue banks that are in trouble?

People have been getting WhatsApp forwards essentially saying that the Modi government is planning to use their bank deposits to rescue all the banks that are in trouble. As is usually the case with WhatsApp, this is not true. The truth is a lot more nuanced.

Let’s try and understand this in some detail.

Where did the idea of fixed deposits being used to rescue troubled banks come from?
The government had introduced The Financial Resolution and Deposit Insurance(FRDI) Bill, 2017, in August 2017. This Bill is currently being studied in detail by a Joint Committee of members belonging to the Lok Sabha as well as the Rajya Sabha.

The basic idea behind the FRDI Bill is essentially to set up a resolution corporation which will monitor the health of the financial firms like banks, insurance companies, mutual funds, etc., and in case of failure try and resolve them.

The Clause 52 of the FRDI Bill uses a term called “bail-in”. This clause essentially empowers the Resolution Corporation “in consultation with the appropriate regulator, if it is satisfied that it necessary to bail-in a specified service provider to absorb the losses incurred, or reasonably expected to be incurred, by the specified service provider.”

What does this mean in simple English? It basically means that financial firms or a bank on the verge of a failure can be rescued through a bail-in. Typically, the word bailout is used more often and refers to a situation where money is brought in from the outside to rescue a bank. In case of a bail-in, the rescue is carried out internally by restructuring the liabilities of the bank.

Given that banks pay an interest on their deposits, a deposit is a liability for any bank.
The Clause 52 of FRDI essentially allows the resolution corporation to cancel a liability owed by a specified service provider or to modify or change the form of a liability owed by a specified service provider.

What does this mean in simple English? Clause 52 allows the resolution corporation to cancel the repayment of various kinds of deposits. It also allows it to convert deposits into long term bonds or equity for that matter. Haircuts can also be imposed on firms to which the bank owes money. A haircut basically refers to a situation where the borrower negotiates a fresh deal and does not payback the entire amount that it owes to the creditor.

But there are conditions to this…
The bail-in will not impact any liability owed by a specified service provider to the depositors to the extent such deposits are covered by deposit insurance. This basically means that the bail-in will impact only the amount of deposits above the insured amount. As of now, in case of bank deposits, an amount of up to Rs 1 lakh is insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC). This amount hasn’t been revised since 1993.

Typically, anyone who has deposits in a bank tends to assume that they are 100 per cent guaranteed. But that is clearly not the case. Over the years, the government has prevented the depositors from taking a hit by merging any bank which is in trouble with another bigger bank.

So, to that extent the situation post FRDI Bill is passed, is not very different from the one that prevails currently. It’s just that the government has come to the rescue every time a bank is in trouble and I don’t see any reason for that to change, given the pressure on the government when such a situation arises and the risk of the amount of bad press it would generate, if any government allowed a bank to fail.

Over and above this, Clause 55 of the FRDI Bill essentially states that “no creditor of the specified service provider is left in a worse position as a result of application of any method of resolution, than such creditor would have been in the event of its liquidation.” This basically means that no depositors after the bail-in clause is implemented should get an amount of money which is lesser than what he would have got if the firm were to be liquidated and sold lock, stock and barrel.

While, this sounds very simple in theory, it will not be so straightforward to implement this clause.

So why is the government doing this?
In late 2008 and early 2009, governments and taxpayers all over the world bailed out a whole host of financial institutions which were deemed too big to fail. In the process, they ended up creating a huge moral hazard.

As Mohamed A El-Erian writes in The Only Game in Town“[It] is the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism.”

If governments and taxpayers keep rescuing banks what is the signal they are sending out to bank managers and borrowers? That it is okay to lend money irresponsibly given that governments and taxpayers will inevitably come to their rescue.

In order to correct for this moral hazard, in November 2008, the G20, of which India is a member, expanded the Financial Stability Forum and created the Financial Stability Board. The Board came up with a proposal titled “Key Attributes of Effective Resolution Regimes for Financial Institutions”. This proposal suggests to “carry out bail-in within resolution as a means to achieve or help achieve continuity of essential functions”. India has endorsed this proposal. Hence, unlike what WhatsApp forwards have been claiming this proposal has been in the works for a while now.

But does this really prevent moral hazard?
A bulk of the banking sector in India is controlled by the government owned public sector banks. As of September 30, 2017, these banks had a bad loans rate of 12.6 per cent (for private banks it is at 4.3 per cent).  Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more. The bad loans rate when it comes to lending to industry is even higher. In case of some banks it is close to 40 per cent.

This is primarily because banks over the years, under pressure from politicians and bureaucrats, lent a lot of money to crony capitalists, who either siphoned off this money or overborrowed and are now not in a position to repay. This is a risk that remains unless until the banking sector continues to primarily remain government owned in India.

Also, the rate of recovery of bad loans of banks in 2015-2016, stood at 10.3 per cent.  This does not inspire much confidence. In this scenario, having a clause which allows the resolution corporation to get depositors to pay for the losses that banks incur, is really not fair. The moral hazard does not really go away. The bankers, politicians and crony capitalists, can now look at bank deposits to rescue banks. As of now, the government and the taxpayers have kept rescuing public sector banks, by infusing more and more capital into them. Now the depositors can take over, if FRDI Bill becomes an Act.

It is worth pointing out here that the other G20 countries which have supported this proposal have some sort of a social security system in place, which India lacks. Given this, deposits are the major form of savings and earnings for India’s senior citizens and clearly, they don’t deserve to be a part of any such risk.

While, any government will think twice before using depositor money to rescue a bank, this is not an option that should be made available to governments or bureaucrats in India. It is a bad idea. It needs to be nipped in the bud.

These are my initial thoughts on the issue. Depending on how the situation evolves, I will continue to write on it.

The column originally appeared on Equitymaster on December 11, 2017.