Who Does Low Inflation “Really” Benefit?

rupee

Every month the ministry of statistics and programme implementation declares the inflation based on the consumer price index. Inflation is essentially the rate of price rise. The inflation for the month of June 2017, came in at 1.5 per cent.

This basically meant that prices in June 2017 overall were higher by 1.5 per cent in comparison to June 2016. This is the lowest inflation that the country has seen over the period of last five years.

Hence, not surprisingly, the government moved very quickly to claim credit. Arvind Subramanian, the chief economic adviser to the ministry of finance, said: “This low, heartening number is consistent with our analysis for some time now.”

This is one of those statements that makes economics the subject that it is, where equally convincing arguments can be made from the two ends of the spectrum.

Allow me to explain.

Low inflation is heartening because the rate of price rise has come down. It needs to be understood here that low inflation does not mean lower prices. It just means that the rate of price rise has come down than in comparison to the past and that is a good thing. Or so the chief economic adviser would like us to believe.

The question is why has the rate of inflation come down? The consumer price index that is used to calculate inflation is made up of a large number of goods and services. The government tracks the prices of these goods and services across the country, in order to arrive at the inflation number.

Food and beverages constitute around 45.9 per cent of the index. Food and beverage prices fell by 1.2 per cent in June 2017 in comparison to June 2016. In fact, prices of some of the constituents like pulses and vegetables have fallen at a much faster rate than the overall rate.

The price of vegetables fell by 16.5 per cent and that of pulses fell by 21.9 per cent. Vegetables and pulses together constitute a little over 8.4 per cent of the index.

So, what does this mean? It means that the overall rate of inflation is down because food prices have actually come down. Lower food prices essentially mean that the farmers growing food, have sold what they grew at a price lower than they had in the past. Also, these lower prices do not always reach the end consumers, with middlemen taking in a bulk of the benefit.

There have been many stories in the media portraying the plight of these farmers who have had to sell their produce at lower than their cost price and face losses and get even more indebted. In fact, it is not surprising that over the last few months, there has been so much demand for loans to farmers to be waived off, all across the country.

The larger point is that if inflation has become very low then someone is not being paid as much as he was in the past. And this can be due to various reasons. In this case that someone happen to be farmers. Farmers form around half the working population. If they face losses then they are less likely to spend as much money as they had in the past. This will impact rural growth and in the process, the overall economic growth.

Hence, when Subramanian finds low inflation heartening, he ignores this line of thought totally. As Evan Davis writes in Post Truth—Why We Have Reached Peak Bullshit and What We Can Do About It: “There are certainly such things as facts, and no one should persuade you otherwise. But aside from quite banal facts (‘the sun is shining’) we always have to use judgement in deciding what is a fact and what to believe: we have to apply a judgement as to the weight of evidence in its support relative to the weight of interpretation put on it.”

The column originally appeared in the Bangalore Mirror on July 19, 2017.

Who Does Low Inflation “Really” Benefit?

rupee

Every month the ministry of statistics and programme implementation declares the inflation based on the consumer price index. Inflation is essentially the rate of price rise. The inflation for the month of June 2017, came in at 1.5 per cent.

This basically meant that prices in June 2017 overall were higher by 1.5 per cent in comparison to June 2016. This is the lowest inflation that the country has seen over the period of last five years.

Hence, not surprisingly, the government moved very quickly to claim credit. Arvind Subramanian, the chief economic adviser to the ministry of finance, said: “This low, heartening number is consistent with our analysis for some time now.”

This is one of those statements that makes economics the subject that it is, where equally convincing arguments can be made from the two ends of the spectrum.

Allow me to explain.

Low inflation is heartening because the rate of price rise has come down. It needs to be understood here that low inflation does not mean lower prices. It just means that the rate of price rise has come down than in comparison to the past and that is a good thing. Or so the chief economic adviser would like us to believe.

The question is why has the rate of inflation come down? The consumer price index that is used to calculate inflation is made up of a large number of goods and services. The government tracks the prices of these goods and services across the country, in order to arrive at the inflation number.

Food and beverages constitute around 45.9 per cent of the index. Food and beverage prices fell by 1.2 per cent in June 2017 in comparison to June 2016. In fact, prices of some of the constituents like pulses and vegetables have fallen at a much faster rate than the overall rate.

The price of vegetables fell by 16.5 per cent and that of pulses fell by 21.9 per cent. Vegetables and pulses together constitute a little over 8.4 per cent of the index.

So, what does this mean? It means that the overall rate of inflation is down because food prices have actually come down. Lower food prices essentially mean that the farmers growing food, have sold what they grew at a price lower than they had in the past. Also, these lower prices do not always reach the end consumers, with middlemen taking in a bulk of the benefit.

There have been many stories in the media portraying the plight of these farmers who have had to sell their produce at lower than their cost price and face losses and get even more indebted. In fact, it is not surprising that over the last few months, there has been so much demand for loans to farmers to be waived off, all across the country.

The larger point is that if inflation has become very low then someone is not being paid as much as he was in the past. And this can be due to various reasons. In this case that someone happen to be farmers. Farmers form around half the working population. If they face losses then they are less likely to spend as much money as they had in the past. This will impact rural growth and in the process, the overall economic growth.

Hence, when Subramanian finds low inflation heartening, he ignores this line of thought totally. As Evan Davis writes in Post Truth—Why We Have Reached Peak Bullshit and What We Can Do About It: “There are certainly such things as facts, and no one should persuade you otherwise. But aside from quite banal facts (‘the sun is shining’) we always have to use judgement in deciding what is a fact and what to believe: we have to apply a judgement as to the weight of evidence in its support relative to the weight of interpretation put on it.”

The column originally appeared in the Bangalore Mirror on July 19, 2017.

Mr Subramanian, Lower Interest Rates Do Not Always Lead to More Bank Loans

Arvind_Subrahmaniyam

“Lower interest rates lead to higher lending,” is something that most economists firmly believe in. The beliefs of Arvind Subramanian, the chief economic adviser to the ministry of finance, are not an exception to this rule.

Hence, not surprisingly in a lecture a few days back he came out all guns blazing against the Reserve Bank of India(RBI) for not cutting the repo rate. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loan. We say sort of a benchmark here because there are other factors which go into deciding what rate of interest that banks charge on their loans.

Subramanian wants the RBI to cut the repo rate further from its current level of 6.25 per cent. As he said: “Inflation pressures are easing considerably… the inflation outlook is benign because of a number of economic developments… Against this background, most reasonable economists would say that the economy needs all the macroeconomic policy support it can get: instead, both fiscal policy and monetary policy remain tight.

The point here being that current inflation is under control and from the looks of it, future inflation should also be under control. And given this, the RBI must cut its repo rate. The RBI last cut the repo rate in October 2016. And as and when it cuts the rate further, the hope is that the banks will cut their lending rates. Only then will people and industries both borrow and spend more. This will give a flip to the economy. QED.
Subramanian’s point is well taken. Nevertheless, does it make sense? We will deviate a little here before we arrive at the answer.

The RBI Monetary Policy Report released in early April 2017 points out that the decline in the one-year marginal cost of funds based lending rates (MCLRs) of banks between April and October 2016 was just 15 basis points. This when the repo rate was cut by 50 basis points. Hence, even though the RBI cut its repo rate by 50 basis points, the banks cut their lending rates by just 15 basis points, a little under a one-third. One basis point is one hundredth of a percentage.

Post demonetisation “27 public sector banks have reduced their one-year median MCLR in the range of 50 to 105 bps, and 19 private sector banks have done so in the range of 25 to 148 bps.” This when the repo rate has not been cut at all. On an average the one year MCLRs of banks fell by 70 basis points to 8.6 per cent.

What has happened here? A cut in the repo rate barely makes any difference to the cost at which banks have already borrowed money to fund their loans. But demonetisation did. The share of the “low cost current account and savings account (CASA) deposits in aggregate deposits with the SCBs went up to 39.2 per cent (as on March 17, 2017) – an increase of 4.0 percentage points relative to the predemonetisation period”. This is because people deposited the demonetised notes into the banks and this money was credited against their accounts.

This basically meant that banks suddenly had access to cheaper deposits because of demonetisation. And this in turn led them to cut interest rates on their loans, despite no cut in the repo rate. The RBI’s repo rate continued to be at 6.25 per cent during the period.

A cut in lending rates is only one part of the equation. The bigger question has it led to higher borrowings? Are people and businesses borrowing more because lending rates are now lower than they were in the past? And this is where things become interesting.
The total deposits of banks between October 28, 2016 (before demonetisation) and December 30, 2016 (the last date to deposit demonetised currency into banks) went up by 6.41 per cent to Rs 10,568,17 crore. This was a huge jump during a period of two months. This sudden increase in liquidity led to banks cutting their deposit rates and then their lending rates.

Interestingly, the total deposits of banks have continued to remain stable and as of April 30, 2017, were at Rs 10,509,337 crore. This is a minor fall of 0.6 per cent since December 2016.

Between end October 2016 and end April 2017, only around 36 per cent of the incremental deposits raised by banks were loaned out. (We are looking at non-food credit here. The total bank loans that remain after we adjust for the loans that have been given to the Food Corporation of India and other state procurement agencies for the procurement of rice and wheat produced by farmers).

This means for every new deposit worth Rs 100, the bank loaned out just Rs 36, despite a cut in interest rates.

If we were to look the same ratio between end October 2015 and end April 2016, it projects a totally different picture. 116 per cent of the incremental deposits during the period were lent out. This means for every new deposit worth Rs 100, the bank loaned out Rs 116.  This means that deposits raised before the start of this period were also lent out.

Hence, a greater amount of lending happened at higher interest rates between October 2015 and April 2016. And this goes totally against Subramanian’s idea of the RBI needing to cut the repo rate. It also goes against the idea of banks lending more at lower interest rates.

Given this, low interest rates are only a part of the story. If that is not leading to higher lending, it doesn’t help in anyway. Lending isn’t happening due to various reasons, which we keep discussing. Demonetisation has only added to this issue.

Also, a fall in interest rates hurts those who depend on a regular income from fixed deposits to meet their expenditure. It also hurts those who are saving for their long-term goals. In both the cases, expenditure has to be cut down. In one case because enough regular income is not being generated and in another case in order to be able to save more to reach the investment goal. And this cut in spending hurts the overall economy. Interest rates are also about the saver and depositor.

We are yet to see a professional economist talk from this angle. To them it is always a case of garbage in garbage out i.e. lower interest rates lead to increased lending. This is simply because most professional economists these days get trained in the United States where the system is totally different and lower interest rates do lead to a higher borrowing by businesses and people.

But that doesn’t necessarily work in India. It is a totally different proposition here.

The column originally appeared in Equitymaster on May 15, 2017.

This Labour Law Reform Can Help Create Low-Skilled Jobs That India Needs

jobs

 

One of the fundamental points that Indian policymakers and politicians haven’t understood since independence is that India needs to encourage manufacturing that employs low skilled and unskilled workers.

The public sector enterprises that were launched after independence concentrated on skilled manufacturing, and in the process did not create much employment. The Make in India programme launched by Narendra Modi, made the same mistake initially.

As Ruchir Sharma writes in The Rise and Fall of Nations—Ten Rules of Change in the Post Crisis World: “After Narendra Modi became prime minister in 2014, he launched a “Make in India” campaign. But there was still a basic problem: His aides, at least initially, were not talking about building simple factories first, in industries like toys or textiles, of the kind that can employ many millions of people and jump-start an industrial middle class. They were talking about advanced factories in industries like solar-powered appliances and military weapons, which require the highly skilled workers not yet found in abundance among India’s vast population of rural underemployed. India was trying to skip over a step in the development process, not for the first time.”

On June 22, 2016, the Modi government made a small but very important change in the labour laws that govern the textile sector in India. As the press release put out by the Ministry of Textiles pointed out: “Looking to the seasonal nature of the industry, fixed term employment shall be introduced for the garment sector. A fixed term workman will be considered at par with permanent workman in terms of working hours, wages, allowanced and other statutory dues.

The fact that the move has come nearly two years after Modi became the prime minister tells us that the Indian establishment still remains enamored by the idea of skilled manufacturing.

Nevertheless, this a very important move. As Amrit Amirapu and Arvind Subramanian write in a research paper titled Manufacturing or Services? An Indian Illustration of a Development Dilemma: “Historically, there have been three modes of escape from under-development: geology, geography, and “jeans” (code for low-skilled manufacturing).”

In fact, the East Asian countries that escaped poverty did so by jumping on to the jeans or the low-skilled manufacturing bandwagon. As Amirapu and Subramanian write: “In the early stages of their success, East Asian countries relied on relatively low-skilled manufacturing, typically textiles and clothing (China, Thailand, Indonesia, Malaysia etc), to motor economic growth. Later on they diversified into more sophisticated manufacturing but “jeans” offered the vehicle for prosperity early on. No country has escaped from underdevelopment using relatively skill-intensive activities as the launching pad for sustained growth as India seems to be attempting.”

There is no reason that India should have been attempting anything else. But such was the marketing spin, first around public sector enterprises and then around information technology, that manufacturing that employs low-skilled workers was sort of looked down upon. But at the end of the day public sector enterprises and information technology needed skilled workers and given that they could create only so many jobs. And this was nowhere near the number of jobs that India needs.

Most estimates now suggest that India needs to create around one million jobs every month, for fresh individuals who are entering the workforce.

The textiles sector has the ability to create many low-skilled jobs and that gives it a tremendous fit with India’s natural competitive advantage i.e. low-skilled labour. In fact, as Arvind Subramanian and Rashmi Verma point out in a recent column in The Indian Express: “Every unit of investment in clothing generates 12 times as many jobs as that in autos and nearly 30 times that in steel.”

But the irony is that when comes to textiles, even Bangladesh is doing better than India. As Mihir S. Sharma writes in Restart—The Last Chance for the Indian Economy: “Before the expansion of trade thanks to new international rules in the twenty-first century, India made $10 billion from textile exports, and Bangladesh $8 billion. Today India makes $12 billion—and Bangladesh $21 billion.”

So what happened here? The textile industry, explains Sharma, needs to turnaround big orders quickly and efficiently. This means that really long assembly lines are needed. As he writes: “100 people can sequentially work to make a pair of trousers in least time. In Bangladesh, the average number of people in a factory is between 300 and 400; in the South Indian textiles hub of Tirupur, it’s around 50.”

India has very few factories that actually employ more than 500 people.[1] Now compare that with China. The largest garment manufacturing factories in China have a workforce of 30,000. In fact, even Bangladesh has garment manufacturing units with 10,000 workers. In India, the numbers rarely go beyond 1,000 workers. In fact, in India, the garment manufacturers prefer to split their workforce into many units, instead of employing a lot of workers at one unit. This basically comes from the fear of not being able to retrench workers.[2]

In fact, Subramanian and Verma make a similar point in their column in The Indian Express where they say that “an estimated 78 per cent of firms in India employ less than 50 workers with 10 per cent employing more than 500 workers.” “In China, the comparable numbers are about 15 and 28, per cent respectively.”

This leads to a situation where the Indian companies operating in the textiles sector do not have the economies of scale required to compete globally. One of the reasons the Indian companies cannot compete globally is because they can’t hire and fire workers according to the demand for their products.

The government has now introduced the concept of the fixed term contract which allows textile companies to hire workers for a fixed period, instead of offering permanent employment. Up until now companies had been hiring contract workers, who in many cases are not paid as much as permanent workers even though the work being done is exactly the same. The fixed term contracts will also allow companies the flexibility to hire according to their demand. And they won’t have to keep workers on the rolls even when they don’t actually need them.

In fact, this is one factor which has led to many textile companies not taking on more business in the past because once they had hired workers, they wouldn’t have been able to let them go.

As the Eleventh Five Year Plan (2007-2012) pointed out in this context: “Chapter V-B of the Industrial Disputes Act 1947 does create a psychological block in entrepreneurs against establishing new enterprises with a large workforce and impede attainment of economies of scale. As a result, firms prefer to set up enterprises with a smaller permanent workforce, and these enterprises are unable to cope with large size orders from retail market chains in garments and footwear for instance.”

Chapter V-B of the Industrial Disputes Act essentially makes it compulsory for a firm with more than 100 workers, to take the permission of the local government before retrenching workers. This complicates the entire scenario. In the recent past, this limit has been increased to 300 workers in the states of Rajasthan and Madhya Pradesh.

In case of garment manufacturing, a lot of demand is basically export demand. This means that the demand tends to pick sometime before Christmas and New Year, and then it falls. In an ideal scenario this would mean hiring workers just a few months before Christmas and then letting them go, after the garments have been made and shipped. The fixed term contracts will allow companies to do just that, by hiring workers through the formal job market, instead of working through contractors, and short-changing the workers.

The fixed term contracts will encourage textile companies to hire more workers. Nevertheless, they will still think going beyond 100 workers (or 300 workers in some cases) because then the Chapter V-B of the Industrial Disputes Act, 1947, is likely to kick-in.

[1] Annual Survey of Industries 2013-2014

[2] A.Hoda and D.K.Rai, Labour Regulations and Growth of Manufacturing and Employment in India: Balancing Protection and Flexibility, Written for the World Bank, ICRIER, 2015

The column originally appeared in Vivek Kaul’s Diary on July 5, 2016

Why Does Economic Survey Not Talk About Subsidy on Stocks?

Arvind_Subrahmaniyam

I know this piece is not going to go down well with a section of readers. Nevertheless, I think this is an important point and needs to be made.

In January 2016, the prime minister Narendra Modi during the course of a speech had said: “Why is it that subsidies going to the well-off are portrayed in a positive manner? Let me give you an example. The total revenue loss from incentives to corporate tax payers was over Rs 62,000 crore… Dividends and long-term capital gains on shares traded in stock exchanges are totally exempt from income tax even though it is not the poor who earn them.”

Not surprisingly, the Economic Survey released on February 26, 2016, under the leadership of Arvind Subramanian, the chief economic adviser, has a chapter titled Bounties for the Well-Off, dedicated to the implicit subsidies on offer to the rich.

The Economic Survey focuses on “seven areas: small savings schemes, kerosene, railways, electricity, LPG, gold, and aviation turbine fuel (ATF),” and calculates the implicit subsidies available to the rich. The total cost of the implicit subsidies works out to Rs 1.03 lakh crore, as per the survey. Now that’s a huge number.

One of the investment avenues that the Economic Survey calculates an implicit subsidy on is the public provident fund(PPF) scheme in which an individual can invest up to Rs 1.5 lakh every year.  While calculating the taxable income, the amount invested in the PPF scheme can be claimed as a deduction. Further, the amount that the investor gets on maturity is also tax-free. This pushes up the effective returns on PPF.

As the Economic Survey points out: “The effective returns to PPF deposits are very high, creating a large implicit subsidy which accrues mostly to taxpayers in the top income brackets. The magnitude of this implicit subsidy is about 6 percentage points – approximately Rs 12,000 crore in fiscal cost terms.

Along similar lines, the subsidy on the cooking gas cylinder is also captured by the rich. As the Survey points out: “LPG consumers receive a subsidy of Rs 238.51 per 14.2 kg cylinder7 (as in January 2016), which amounts to a subsidy rate of 36 per cent (ratio of subsidy amount to the market price). It turns out that 91 per cent of these subsidies are accounted for by the better-off as their share of consumption of LPG in the total consumption is about 91 per cent; while the poor account for only 9 per cent of LPG consumption and hence only 9 per cent of subsidies go to them.”

What Subramanian doesn’t talk about in the Economic Survey, are the issues on which Modi talked about in January i.e. the implicit subsidy on there being no tax on dividends earned through shares as well as no long-term capital gains tax on selling shares. The reason for that is obvious. It was said that prime-minister Modi was wrongly briefed on the issue at that point of time. And that is largely correct.

Companies distributing dividends, do pay a dividend distribution tax(DDT) to the government. Hence, to that extent the dividend is not tax free in the hands of the investor. If there was no DDT, the shareholders would have received a higher dividend. Nevertheless, the tax is just a better way for the government to collect tax, than collecting it from the investors who earn dividends and then hoping that they declare the divided while filing their tax returns and pay a tax on it.

As far as long term capital gains on shares are concerned, currently there are no taxes to be paid, if the investor sells shares, after holding them for a period of one year or more. The government collects a securities transaction tax (STT) every time an investor buys or sells shares, through a stock exchange.

The STT is collected in lieu of there being no long-term capital gains on selling of shares. In 2014-2015, the government collected close to Rs 6,000 crore through the STT. Also, like DDT, STT is just an easier way of collecting tax, in comparison to the long-term capital gains tax.

Nevertheless, it still does not explain why Subramanian did not calculate the implicit subsidy on there being no long-term capital gains tax on selling shares. A calculation would have told us whether the long-term capital gains tax that could have possibly been collected is more than the amount that the government is collecting through STT.

If the difference is substantial, then the government needs to look at taxing long-term capital gains as well, in the years to come. Obviously, this move will not go down well with the rich who benefit from this implicit subsidy. As David Foster Wallace writes inThe Pale King: “We’ve changed the way we think of ourselves as citizens. … We think of ourselves now as eaters of the pie instead of as makers of the pie.”

Also, it needs to be pointed out that many stock market investors do not like the idea of a long-term capital gains tax on stocks. They also justify the short term capital gains tax at 15%. This rate is much lower than the highest rate of 30% that needs to be paid on all other kinds of income.

The logic is as follows. Stock market investment is risky in comparison to other forms of investing where the amount of money invested is more or less guaranteed. Also, through the stock market entrepreneurs raise capital and investors need to be encouraged to invest in new businesses, and hence, there is no long-term capital gains tax on stocks.

While this may have been valid in the twentieth century, it is worth asking whether this continues to make sense. As the celebrated British economist John Kay writes in Other People’s Money—Masters of the Universe or Servants of the People? : “The first companies to obtain listings on modern markets were companies like railways and breweries, with large requirements for capital for very specific purposes. Building a railway is expensive, and once you have built it the only thing you can do with it is run trains. You cannot use a brewery except to brew beer. Early utilities and manufacturing corporations raised large amounts of money in small packets from private individuals.”

But does that continue to hold good? Do entrepreneurs continue to use the stock market to raise capital for new ventures? As Satyajit Das writes in The Age of Stagnation: “The nature of stock markets has been changed by alternative source of risk capital: the high cost of a stock market listing, particularly increasing compliance costs; increased public disclosure and scrutiny of activities, including management remuneration; and a shift to different forms of business ownership, such as private equity.”

What this means is that more and more entrepreneurs are now raising money through other routes, in the initial stages of their business. This becomes clear in the Indian context from the fact that the number of initial public offerings have come down over the years. But entrepreneurs continue to raise through other routes like private equity, venture capitalists, debentures etc.

The stock market only comes into the picture when these initial investors want to offload their stocks in the firm. As Kay puts it: “Stock market is not a way of putting money into companies, but a means of taking it out.

Hence, all the logic about investors needing to be encouraged to invest in new businesses doesn’t really hold anymore because most of the time, companies now come to the stock market only when they are looking for an exit option for their big initial investors.

In fact, Subramanian and his team could have done some analysis around this issue and told us what portion of the initial public offerings over the last few years raised fresh capital and what portion was investors trying to exit. This is something that the chief economic adviser clearly needs to look at in the next Survey.

And as far as risk of investing in the stock market is concerned. That still remains. But that is the choice that the investor investing in the stock market is making. Why should the government compensate him for it? Beats me.

The column originally appeared in the Vivek Kaul  Diary on February 29, 2016