What a Mumbai Real Estate Agent Can Tell You About Indian Economy Contracting

Koi yahan aaha naache naache,
Koi wahan aahe naache naache.

— Usha Uthup, Faruk Kaiser, Bappi Lahiri and Babbar Subhash (better known as B Subhash), in the Disco Dancer

The gross domestic product (GDP) figures for the period July to September 2020 were published yesterday. The GDP is a measure of the economic size of a country during a particular period. The Indian GDP or the economic size of the country during the period contracted by 7.54%  against the same period last year.

This looks very good in comparison to the contraction of 23.92% that the economy had seen during the period April to June 2020 and has led to the uncorking of the bubbly among a certain set of politicians, economists, analysts, journalists, stock market wallahs and Twitter warriors.

Of course, there is no denying that a contraction of 7.54% is a lot better than a contraction of 23.92%, one would be a fool to deny that. But has the time to uncork the bubbly come? Or, if you are not the drinking type, should we be high-fiving on this one?

Let’s take a look at this pointwise.

1) For much of the period between April to June, the economy was under a lockdown. Once the economy was opened up, things were bound to improve. Hence, a better performance in July to September should not come as a surprise. Second, the period benefitted because of a lot of pent up demand. People who could not buy the stuff they wanted to during April to June, ended up buying it between July to September. These points need to be kept in mind.

2) The economists were expecting a contraction of 8.5-9% during the quarter. Against that a contraction of 7.54% looks just about a little better. Having said that, India has a large unorganised sector. Measuring the value added by the unorganised sector is never easy. Hence, when releasing GDP data for a period of three months for the first time, the National Statistical Office (NSO) essentially proxies the value added by the informal sector using formal sector data. This is set right as data streams in over a period of time.

Over and above this, we are in midst of a pandemic and hence, collection of data isn’t easy. As the NSO points in its release: “Some other data sources such as GST, interactions with professional bodies etc. were also referred to for corroborative evidence and these were clearly limited.”

What this means is that the GDP data presents a picture which is rosier than the actual picture.

3) There is another important point that needs to be made here. India has been publishing quarterly GDP for close to 24 years now. This is only the second time in all these years that the GDP during a particular period of three months has contracted. Only twice in 94 quarters has the economy contracted. And given that GDP has contracted in two consecutive quarters, India is in a midst of what economists call a technical recession. If the economy continues to contract in the months to come, it will enter a recession. That’s the difference between a recession and a technical recession.

Source: Centre for Monitoring Indian Economy.

4) In the period April to June with a contraction of 23.92%, India was the worst performing economy among the major economies in the world. From the data that is currently available on the OECD website, India is no longer the worst performing economy in the world, nonetheless, it continues to be among the worst performing economies in the world.

Source:  https://stats.oecd.org/index.aspx?queryid=350

5) A major surprise in the GDP data has been the recovery of the manufacturing sector. The sector grew by 0.62%, after contracting (or degrowing as analysts like to say) by 39.30% between April to June. While this is good news, it goes against the fact that index of industrial production contracted by 6.09% during July to September. If the production has contracted how has the growth come about? The growth has come primarily from the fact that companies in the listed space have been able to increase their profit margins primarily because of controlling costs, this includes firing employees and slashing their salaries.
As economist Mahesh Vyas recently wrote in a column: “In the September 2020 quarter, while sales fell again by 9.7 per cent, profits sprang a surprise by scaling up by a handsome 17.8 per cent. Yet, wages declined by one per cent. Evidently, companies do not apportion resources to labour in any proportion of profits.”

6) Sectors like construction, mining as well as services continued to remain weak, though better than they were during April to June. These sectors are high employment sectors. This remains a worry given that what seems to be happening currently is a recovery which isn’t creating enough jobs. In fact, financial services, real estate and professional services (bundled together for some reason in the GDP data) contracted by 8.09% during July to September. It had contracted by 5.33% during April to June. And that can’t possibly be a good thing. This can also be seen under NREGA data where demand for jobs this year remains astonishingly higher than last year. It can also be seen in the labour participation rate contracting with people stopping to look for jobs because they are unable to find one, and hence, dropping out of the workforce.

It also needs to be said here if there is a second round of covid, as is being feared, the services sector will continue to remain weak, in particular services like restaurants, hotels, tourism, cinema halls, malls etc.

7) If we look at GDP from the expenditure side, the private consumption expenditure contracted by 11.32% against a contraction of 26.68% between April to June. Clearly, there has been improvement on this front. Nevertheless, private consumption expenditure forms more than half of the Indian economy, and as long as it continues to remain weak, the economy will continue to remain weak. Also, we need to remember that the contraction of 11.32% happened despite pent up demand and festivals in the Western and Southern part of the country. Further, the fact that private consumption has continued to contract, brings into question the growth in the manufacturing sector. Are actual sales happening at the consumer level or is this simply a case of a  build-up of inventory, as has been the case in the auto industry?

8) This is a slightly technical point but still needs to be made. On the expenditure side, the GDP is calculated as a sum of private consumption expenditure, investment, government expenditure and net exports. Net exports is exports minus imports. In the Indian case, this is a negative entry into the GDP figure, given that exports are usually less than imports. During July to September, net exports is a positive number, given that imports are lower than exports, having fallen by a much higher rate. This is primarily because of a collapse in consumer demand, which is not a good thing. When it comes to the goods part of imports, the non-oil non-gold non-silver part of imports collapsed by 23.82% during July to September. This helped push up the GDP number.

9) The GDP has contracted by 15.67% during the first six months of the year. If the economy contracts by 3-5% during the second half of the year, we still are looking at 9-10% contraction this year. This was largely the consensus forecast made for this year. Even if there is no contraction in the second half of the year, the economy will still contract 7.66%, which will make India one of the worst performing economies in 2020-21. Also, we need to remember that the GDP of 2019-20 is likely to be crossed now only in late 2021-22 or 2022-23. So this pushes the Indian economy back by at least two years. Of course a lot of it is because of covid, but let’s not forget, the Indian economy had been slowing down even before the pandemic struck.

10) Let me close this piece with a little story. Sometime in April 2006, I first started to look for a flat to rent, in Mumbai. Of course, one had to go through agents. Pretty soon, I realised that the agents were trying a psychological trick on me. They first showed me a flat which was in a very bad state. They would then show me something which was slightly better. Nevertheless, the difference in rent between the flat was much more than the difference in their quality, with the rent of the second flat being much more than the first one. I caught on to this because I had read this book called Freakonomics sometime in 2005. The book had an extended chapter on the contrast effect.

We all tend to compare things before making a decision. Given this, the attraction of an option can be increased significantly by comparing it to a similar, but worse alternative. This is known as the ‘contrast effect’.

How does this apply in the present context? It’s simple. The fact that the Indian economy contracted by a massive 23.92% during April to June, it makes a contraction of 7.54% during July to September, much better. But there are many nuances, as explained above, that need to be taken into account.

PS: My writing has been highly irregular over the last few weeks. I was busy with a project I had taken on. Now that I am done with it, will write more regularly.

Interest on Interest Case Can Open a Pandora’s Box. Govt and SC Need to Be Careful

Late last week the central government told the Supreme Court that it was ready to waive off the interest on interest (i.e. compound interest) on loans of up to Rs 2 crore during the moratorium period of six months between March and August 2020.

In an affidavit submitted to the Court, the government said: “The government… has decided that the relief on waiver of compound interest [interest on interest] during the six month moratorium period shall be limited to the most vulnerable category of borrowers. This category of borrowers, in whose case, the compounding of interest will be waived, will be MSME loans and personal loans up to Rs 2 crore.”

This response was as a part of the matter of Gajendra Sharma versus the Union of India.

The Reserve Bank of India refers to retail loans as personal loans. Hence, the types of loans which would get a waiver of compound interest for a period of six months of the moratorium are home loans, vehicle loans, education loans, consumer durables loans, credit card outstandings, normal personal loans and MSME loans. This benefit will be available to all borrowers who have taken loans of up to Rs 2 crore, irrespective of whether they opted for the moratorium or not.

Before offering my views on this, let’s first try and understand the concept of compound interest or interest on interest.

Let’s consider a home loan of Rs 2 crore to be repaid over a period of 20 years (or 240 months) at the rate of 8% per year. Let’s further assume that the loan was taken during the month of March and was immediately put under a moratorium (the need to make this assumption will soon become clear).

The moratorium lasted six months. The simple interest on the loan of Rs 2 crore amounts to Rs 8 lakh (8% of Rs 2 crore divided by 2). This is not how banks operate. They calculate interest on a monthly basis. At 8% per year, the monthly interest works out to 0.67% (8% divided by 12). The interest for the first month works out to Rs 1.33 lakh (0.67% of Rs 2 crore).

Since the loan is under a moratorium and is not being repaid, this interest is added to the loan amount outstanding of Rs 2 crore.
Hence, the loan amount outstanding at the end of the first month is Rs 2.013 crore (Rs 2 crore + Rs 1.33 lakh). In the second month, the interest is calculated on this amount and it works out to Rs 1.34 lakh (0.67% of Rs 2.013 crore).

In this case, we calculate interest on the original outstanding amount of Rs 2 crore. We also calculate the interest on Rs 1.33 lakh, the interest outstanding at the point of the first month, which has become a part of the loan outstanding.

At the end of the second month, the loan amount outstanding is Rs 2.027 crore (Rs 2.013 crore + Rs 1.34 lakh).  This happens every month, over the period of six months, as can be seen in the following table.

Interest on interest

 

Source: Author calculations.

At the end of six months, we end up with a loan outstanding of Rs 2.081 crore. This is Rs 8.134 lakh more than the initial loan outstanding of Rs 2 crore. As mentioned initially, the simple interest on Rs 2 crore at 8% for a period of six months works out to Rs 8 lakh.

Hence, the interest on interest works out to Rs 13,452 (Rs 8.134 lakh minus Rs 8 lakh).

What was the point behind doing all this math and trying to explain compound interest here?

The maximum amount on which the government is ready to waive off interest on interest is Rs 2 crore. For the kinds of loan under consideration Rs 2 crore outstanding is likely to be either on a home loan or a SME loan. In case of an SME loan, the interest rate will probably be more than 8%.

On a home loan of Rs 2 crore at 8% with 240 instalments (20 years) left to pay, the interest on interest for a period of six months works out close to Rs 13,500. The point is if an individual can afford to take on a loan of Rs 2 crore at 8% interest and pay an EMI of Rs 1.67 lakh, he can also pay an interest on interest of Rs 13,452. In case of an SME loan, the interest on interest would be higher than Rs 13,432, but it wouldn’t be an unaffordable amount. So, what’s the point of doing this?

An estimate made by Kotak Institutional Equities suggests that this move is likely to cost the government around Rs 8,000 crore (Rs 5,000 crore for banks + Rs 3,000 crore for non-banking finance companies (NBFCs)). While Rs 8,000 crore isn’t exactly small change but it’s not a very large amount for the central government.

But that’s not the point here. This move and the Supreme Court dabbling in this case will end up opening a pandora’s box. Let’s take a look at this pointwise.

1) Media reports suggest that the Supreme Court is not happy with the government’s offer to waive off interest on interest. A report on NDTV.com suggests that waiving interest on interest on loans of up to Rs 2 crore “was not satisfactory and asked for a do-over in a week”.

As the report points out: “The affidavit “fails to deal with several issues raised by petitioners”, the court said. The central government has been asked to consider the concerns of the real estate and power producers in fresh affidavits.” Clearly, neither the Court nor the companies are happy with interest on interest of loans of up to Rs 2 crore being waived off.
By offering to waive off interest on interest the government is trying to meet the Court halfway. Also, it is important that the Court along with the government realise that they are interfering with the process of interest setting by banks, something that largely works well.

What is interest at the end of the day? Interest is the price of money. By taking on this case, the Supreme Court has essentially gotten into deciding the price of money. When a bank pays an interest to a deposit holder, it is basically compensating the deposit holder for not spending the money immediately and saving it. This saving is then lent out to anyone who needs the money. This is how the financial intermediation process works.

The government and the Court are both trying to fiddle around with the price of money and that is not a good thing. Today one set of companies have approached the Court to decide on the price of money, tomorrow another set might do the same.

2) The companies are clearly not happy with the interest on interest waiver offer primarily because their loans are greater than Rs 2 crore and they want more. This is hardly surprising.

In the affidavit the government has said: “If the government were to consider waiving interest on all the loan and advances to all classes and categories of borrowers corresponding to the six-month period for which the moratorium was made available under the relevant RBI circulars, the estimated amount is Rs 6 lakh crore.”

To this, the response of the real estate lobby CREDAI was: “A lot of facts and figures in the government’s affidavit are without any basis and the finance ministry’s estimate that waiving off interest on loans to every category would cost banks Rs 6 lakh crore is wrong.”

It is easy to verify this with a simple back of the envelope calculation. As of March 2020, the non-food credit of banks was at Rs 103.2 lakh crore. The banks give loans to Food Corporation of India and other state procurement agencies to buy rice and wheat directly from farmers. Once these loans are subtracted from the overall loans of banks, what is left is non-food credit.

The weighted average lending rate of scheduled commercial banks was at 10% in March 2020 (This is publicly available data). Just the simple interest on non-food credit for six months works out to Rs 5.16 lakh crore (10% of Rs 103.2 lakh crore divided by 2).

Over and above this, there is lending carried out by NBFCs, on which interest on interest will have to be waived off as well. Also, once we take compound interest into account, Rs 6 lakh crore is clearly not a wrong figure as CREDAI wants us to believe.

The weighted average lending interest rate has fallen a little since March. In August, the weighted average lending rate of scheduled commercial banks was at 9.65%. Even after taking this into account, Rs 6 lakh crore is not an unrealistic number at all.  The government and the SC need to be careful regarding any demands of lowering interest rates on loans.

3) The real estate companies have an incentive in getting as much from the Court as possible. Financially, many of them are overleveraged. In fact, the former RBI Governor Urjit Patel in his book Overdraft refers to them as ‘living dead’ borrowers or zombies. And a living dead borrower will go as far as possible to survive at the cost of others. Any new bailout allows them to survive in order to die another day. Also, it allows them to continue not cutting home prices.

Clearly, companies want some reworking on the interest front (the interest on interest for a period of six months isn’t going to amount to much). But this raises a few fundamental questions.

If the Court and the government get around to cutting interest rates on loans, they will be deciding on the price of money. If they do it this one time, they are basically giving Indian capitalists the idea that they can approach the courts and challenge the price of money being charged. What stops it from happening over and over again?

While the government does try and influence the interest rates charged on loans by public sector banks, it can’t do so when it comes to private banks, which now form around 35% of the market when it comes to loans. Nevertheless, if any decision lowering interest rates is made they will end up influencing the price of money of private banks as well. And that isn’t a good thing. The last thing you want in a period of economic contraction is to try and disturb the banking system in any way.

4) Also, any interest rate waiver or reduction will give political parties ideas, like waiving off agricultural loans they can waive off other loans as well. And that can’t be a good thing for the stability of the Indian banking system.

5) If the government really wants to help businesses it can do so by reforming the goods and services tax and making it more user friendly. That will go a much longer way in helping the Indian economy without disturbing a process which currently works well. Any fiddling around with interest rates is largely going to help only zombie companies.

As Urjit Patel writes in Overdraft: “Sowing disorder by confusing issues is a tried-and-trusted, distressingly often successful routine by which stakeholders, official and private, plant the seeds of policy/regulation reversal in India.” This time is no different. Hence, both the government and the Supreme Court need to be very careful in how they deal with this. It is ultimately, the hard earned money of millions of Indians which is at stake. The Indian banking system is one of the few systems which people continue to trust. You wouldn’t want that to break down.

 

Explained: Why Central Govt Needs to Compensate States for Collapse in GST Collections

Summary: I went looking for the legal reasons being offered by the central government to not compensate the state governments for the dramatic fall in GST collections. I found a central government paper explaining the logic with a lot of legalese. This piece tries to summarise the legalese in simple English. Along with that, I offer many reasons as to why the central government needs to adequately compensate the states. This is definitely not something you will read in the mainstream media.

As has been reported almost everywhere by now, the central government doesn’t want to compensate the state governments for a shortfall in goods and services tax (GST) collections that is going to happen through this year.

In an earlier piece I had explained why this was a bad decision. In today’s piece we will try and understand the central government’s reasoning behind this decision, at the same time we shall also see why the central government is in a much better position to deal with the situation than states are.

The Story So Far

The GST collections between April and June this year have been around 34.5% lower at Rs 2.73 lakh crore than during the same period in July 2019. As the economy contracts in the aftermath of covid-19, the collections will continue to remain subdued during the remaining part of the year.

The central government needs to share a significant part of the GST with the state governments. Over and above this, there is also a guarantee of 14% growth in GST collections for states for the first five years until 2022. If this is not achieved, the central government needs to compensate the state governments for any shortfall.  The central government has decided not to do so.

The Legalese

This public paper explains the central government’s position on the issue. Let’s see why the government is saying what it is saying.

The Constitution (101st Amendment) Act 2016 contains the following provision:

“Parliament shall, by law, on the recommendation of the Goods and Services Tax Council, provide for compensation to the States for loss of revenue arising on account of implementation of the goods and services tax [emphasis added] for a period of five years.”

Following the above provision, the Parliament enacted the Goods and Services Tax (Compensation to States) Act 2017. The preamble of this Act reads as follows:

“An Act to provide for compensation to the States for the loss of revenue arising on account of implementation of the goods and services tax [emphasis added] in pursuance of the provisions of the Constitution (One Hundred and First Amendment) Act.”

In fact, the emphasised parts (in bold italics) in both the 101st amendment as well as the Goods and Services Tax (Compensation to States) Act 2017, read exactly the same. What does this mean in simple English? It means that state governments will be provided a compensation if there is a loss of revenue on account of problems with the implementation of GST (of course, there have been problems galore, but let’s not go there now).

Hence, the central government could have used this technicality in denying the state governments any compensation for a fall in GST collections.

As the policy paper referred to earlier points out: “The Constitution and the preamble to the Act lay out the spirit and purpose of the GST compensation: namely that it is to compensate states for loss of revenue “arising on account of implementation of GST”. The wording of the Constitution and statutory preamble make it clear that the spirit of the law is not to compensate states for all types of revenue losses, but rather for that loss arising from GST implementation.” Ultimately, the GST collections in 2020-21 will fall majorly because of the negative economic impact of the covid-19 pandemic and not just because of the loss of revenue thanks to the botched up implementation of the GST by the central government.

The interesting thing is that the government hasn’t used the above explanation to deny compensating the states for the GST shortfall. It has gone deeper into the legalese to deny the states a compensation.

But before we get into that, the central government has this to say about the GST shortfall: “Parliament obviously could not have contemplated a historically unprecedented situation of huge losses of revenue [thanks to the spread of covid-19] from the base—arising from an Act of God [emphasis added] quite independently of GST implementation—affecting both Central and State revenues, direct and indirect.”

This is where the act of god phrase came into being, also telling us that the government doesn’t do or say anything without putting it on kagaz [paper] first.

Now let’s get back to why the government has denied compensating the states for the GST shortfall. The Section 7 of the the Goods and Services Tax (Compensation to States) Act 2017, provides the detailed mechanism for the calculation as well as the payment of compensation to the state governments when there is a shortfall.

Nevertheless, Section 7 doesn’t make any distinction between the shortfall in GST collections happening due to implementations reasons and non-implementation reasons. As the government paper points out: “Compensation is payable for the entire shortfall (even if it is not on account of GST implementation). This position has been clarified by the Attorney General and is accepted by the Central Government [emphasis in the original].”

So, if this interpretation has been accepted by the central government, why isn’t it compensating the state governments? If your head is already spinning by now, I don’t blame you for it. The legalese behind which the central government is hiding keeps getting better. Let’s move ahead.

The Section 10 of the Goods and Services Tax (Compensation to States) Act 2017 prescribes the manner of payment of the compensation to state governments in case of a shortfall. Let’s look at this pointwise.

1) The compensation is to be paid out of the non-lapsable GST Compensation Fund.

2) Money flows into the GST Compensation Fund from the GST Compensation Cess levied on sin and luxury goods under Section 8, which includes everything from cigarettes to expensive cars. This is made clear under Section 10(1).

3) Section 10(1) also makes it clear that money can flow into the GST Compensation Fund through “such other amounts as may be recommended by the Council”. Hence, other than the GST Compensation Cess only something cleared by the Council can flow into the GST Compensation Fund.

4) Section 10(2) says that compensation under Section 7 “shall be paid out of the Fund”.

Basically, what the government is saying here is that any compensation to state governments on account of a loss of revenue needs to be paid out of the GST Compensation Fund.

So, the government summarises its position by saying: “The states are entitled to compensation…regardless of the cause of the shortfall. However, compensation is to be paid only from the Compensation Fund and it is not an obligation of the Government of India in the event of a shortfall. It is for the GST Council to decide on the mode of making good the shortfall.”

Of course, with the GST collections falling, the compensation cess will not be enough to make up for the shortfall. Also, what the central government is saying is that the GST Council is a different entity from it. This is the point being made on the basis of some complicated legalese. And this rather complicated legalese has been used to basically shaft, for the lack of a better word, the state governments. The central government paper also talks about the spirit of the law.

As far as the act of god point goes, if a fall in GST collections due to covid-19 is act of god for the central government, it is also an act of god for the state governments as well. What are they expected to do in such a scenario?

And given that, the law needs to be changed, simply because the facts have changed and the situation that has arisen currently wasn’t taken into account when the law was first framed. If every law was perfect as it was written first time around, there wouldn’t be so many amendments going around. As the famous British economist, John Maynard Keynes, once supposedly said: “When the facts changeI change my mind. What do you do, sir?

The Central Government Needs to Compensate

The central government needs to compensate the state governments for this shortfall in GST collections. The state governments are at the forefront of fighting the pandemic and hence, need money. Also, state governments spend more money than the central government during the course of any year and that needs to be kept in mind as well, in a scenario, where the private expenditure has collapsed dramatically post covid.

Also, as the government paper points out: “The notion of borrowing by the GST Council is not practically or legally feasible or desirable. This leaves the options of Central or state borrowing.” Let’s look at what the central government is offering the states as a compensation.

1) The shortfall arising out of the loss of revenue due to the GST implementation has been estimated by the central government to be at Rs 97,000 crore. The state governments can borrow this money under a special window coordinated by the finance ministry. The states can repay both principal and interest by using the money they receive from the compensation cess. Also, this borrowing shall not be treated as debt. Hence, it will not limit any state’s overall borrowing ability.

2) The overall shortfall (thanks to implementation and covid impact) in GST collections has been estimated to be at Rs 2.35 lakh crore. The state governments can borrow this entire amount from the market. An amount of Rs 1.38 lakh crore (Rs 2.35 lakh crore minus Rs 97,000 crore) will be considered to be as debt of the state governments. The state governments will have to repay this debt from their own resources. They can repay the principle from the compensation cess.

The government’s logic in getting states to borrow directly from the market is rather bizarre. Nevertheless, let’s take a look at this.

This is what the government paper says: “The Government of India faces a very large borrowing requirement this year. Additional borrowing by the Centre influences the yields on Central government securities (g-secs) and has other macro-economic repercussions. The yield on G-secs acts as a benchmark for State borrowing as well as private sector borrowing. Hence any rise in Central borrowing costs ipso facto drives up borrowing costs for all borrowers, including not only the States but also the entire private sector. On the other hand, the yields on State Government securities do not directly influence other yields and do not have the same type of macroeconomic repercussions.”

What does this mean in simple English (now how many times will I end up saying this)? The central government will end up borrowing more this year than in other years. In this scenario, it will end up needing a greater amount of financial savings to fund itself. This will push up interest rates at which the central government borrows. When the rate of interest at which the central government borrows goes up, the rate of interest for the entire financial system goes up because lending to the central government is the safest form of lending. When this happens, both the private sector as well as the state governments will end up paying higher interest rates on the money they borrow.

The central government’s contention is that the above logic does not apply to when state governments borrow. Their borrowing doesn’t end up pushing overall interest rates.

This is bizarre to say the least. If the state government borrows more from the same pool of savings, it will end up pushing the overall interest rates in the financial system, upwards.

The question is why doesn’t the central government want to borrow more. The government originally expected to borrow Rs 7.8 lakh crore to finance its fiscal deficit in 2020-21. Fiscal deficit is the difference between what a government earns and what it spends. This has already been increased by more than 50% to Rs 12 lakh crore. Any further borrowing will mean, the central government’s already terrible numbers on the fiscal front, will end up looking even more terrible.

I guess that is the logic running in the minds of the babus at the finance ministry and their minister. The trouble is this logic doesn’t hold. Irrespective who borrows, the state governments or the central government, the public debt or the overall debt of the public sector, will go up. Further, there is an implicit sovereign guarantee on state government debt.

As Shaktikanta Das, the governor of the RBI said in November 2019: “There is an implicit sovereign guarantee in them… On the due date of repayment, RBI automatically debits the state government account and makes the repayment. So, there is an implicit sovereign guarantee.” Hence, ultimately, if there is any trouble on this front, it is the central government’s problem.

Further, the central government is in a much better position to raise money. It can sell its stakes in public sector enterprises. It can also sell their land. It has access to a variety of cesses (tax on tax) from which it can earn money. This is money it doesn’t need to share with state governments. It also has access to the profit made by the Reserve Bank of India, as well as its reserves. The ability of the state governments to tax post GST has come down.

Also, various central government institutions (from banks to insurance companies) end up buying bonds issued by the state governments. In that sense the interest on these bonds gets paid to them. The profits made by these institutions end up with the central government, one way or another (corporate income tax/dividends/special dividends etc.).

Hence, there are many reasons as to why the central government should compensate the state governments for a fall in GST collections. But the biggest reason as the deputy chief minister of Bihar, Sushil Modi told the the Press Trust of India: “It is the commitment of the central government to compensate the states for the shortfall in GST collections. It’s true that it is legally not binding on the Centre, but morally, it is.”

Modi belongs to the BJP.

India’s MIDNIGHT TRYST with GST is Turning into a Priyadarshan Comedy

Summary: 

There must be some kind of way outta here
Said the joker to the thief
There’s too much confusion
I can’t get no relief.

— Bob Dylan, All Along the Watchtower.

 

India’s midnight tryst with the Goods and Services Tax (GST) is a little over three years old and is looking more and more like a bad joke which, we brought upon ourselves.

The state of GST takes me back to the last thirty minutes of several Priyadarshan comedies, where everyone is running after everyone else and no one knows what is really happening. (Actually, it can also compared to the ending of the wonderful comedy Andaz Apna Apna).

In reel life, all this confusion has the audience in splits. In real life, those going through the experience feel like they are a part of surreal black comedy.

Yesterday, the finance minister Nirmala Sitharaman said that the covid-19 pandemic was an act of god and that would impact GST collections negatively. An act of god is essentially a natural hazard which is beyond human control, something like an earthquake or a tsunami for that matter. No one can be held responsible for it.

The act of god has led to a situation where the GST collections have nose-dived. This is hardly surprising given that private-consumption has come down over the last few months. Also, by characterising the fall as an act of god, the central government doesn’t want to be held responsible for the fall in GST collections.

Nevertheless, it needs to be said here that GST collections weren’t doing well even before covid-19 struck. Let’s take a look at the growth/fall in GST collections between August 2018 and February 2020, before the covid pandemic struck.

All is well?

   
Source: Centre for Monitoring Indian Economy.

The above chart clearly shows that the growth in GST collections had been falling since early 2019 though it did recover a little since late last year, before stabilizing at half of the peak growth. In November 2018, the growth in GST collections was 16.5%. In February 2020, it was at 8.3%.

The point here being that the growth in GST collections had slowed down since early 2019. It picked up again in late 2019, thanks to a cap on the input tax credit that certain businesses could take. Festival season sales also helped.

This slower growth in GST collections was a reflection of a broader economic slowdown, for which the botched up implementation of GST was also hugely responsible. Of course, the spread of the covid pandemic has only made the situation much worse, with GST collections falling between March and July.

In a normal scenario, a fall in tax collections would mean lower expenditure by the government. But the situation that prevails is nowhere near normal. With private consumption falling, the governments (states and central) are expected to continue spending money, in order to keep the economy going.  Also, state governments are at the forefront of fighting the epidemic and they need money to do that.

The GST collections are split between the central government and the state governments. One of the carrots that the central government had offered to the states in a bid to make GST acceptable and to hasten India’s midnight tryst with GST, was a promise of a compensation if the GST revenues did not grow by 14% from one year to the next. The GST(Compensation to States) Act, guarantees state governments a revenue protection of 14% for the first five years of GST.

Of course, it doesn’t take rocket science to understand that GST revenues will contract in 2020-21, the current financial year. Hence, as per the GST(Compensation to States) Act, state governments need to paid a compensation by the central government.
As per the law, a compensation needs to be paid to state governments every two months. In fact, the compensation due to states for the period April to July 2020, stands at Rs 1.5 lakh crore.

This money comes from the compensation cess which is levied on both sin and luxury goods. The trouble is that like the overall GST collections, the growth in collections of the compensation cess had been falling through most of 2019. This can be seen in the following chart.

To sin or not to sin?


Source: Centre for Monitoring Indian Economy.

In June 2020 and July 2020, the collections of compensation cess fell by 9.4% and 15%, respectively. It needs to be said that even during an economic slowdown or a contraction, the consumption of sin and luxury goods does not fall at the same pace as the overall consumption. But despite that, the compensation cess collected in 2020-21 will not be enough to pay state governments to ensure a 14% growth in overall GST earned.

The shortfall in GST collections as per the central government is expected to be at Rs 2.35 lakh crore. It has said that this shortfall cannot be paid for through the consolidated fund of India, which is a repository for all the money earned by the central government through taxes as well as the money it borrows.

Basically, the central government after promising a 14% growth protection to states on GST, has come back and told them, hey, now that we are in trouble, you are on your own. It reminds me of an old line in buses in North India, sawari apne samaan ke khud zimmedar hai (the travellers are responsible for what they are carrying). The joke, the way the drivers of these buses drove, was, sawari apni jaan ke bhi khud zimmedar hai (the passengers are also responsible for their lives). This is the kind of joke that the central government has just cracked on state governments. This is black humour of the finest kind, which you won’t even see in an Anurag Kashyap movie.

In order to fulfil the gap, the options offered to the state governments by the central government are: 1) To borrow Rs 97,000 crore at a reasonable rate of interest from a special window at the Reserve Bank of India. The Rs 97,000 crore number is an estimate of GST loss due to implementation issues. 2) To borrow the entire gap of Rs 2.35 lakh crore. These options are only for 2020-21. The states can repay the money in the years to come by using the GST compensation cess they receive in the years to come.

This leads to a few points:

1) The central government basically sold the state governments a dummy in promising a 14% growth in GST collections. A narrative was created, it was marketed and then the constituents of the narrative were abandoned.

2) The state governments were also responsible for this to some extent given their resistance to the original law. Also, the central government was in a hurry to ensure India’s midnight tryst with GST, in order to create a narrative.

3) It is easier for the central government to borrow than for the states to do so. It seems here that the central government doesn’t want to spoil its fiscal deficit number any further than it already will this year. Fiscal deficit is the difference between what a government earns and what it spends.

Nevertheless, whatever be the case, the total government borrowing (centre + states) is bound to go up. So, I really can’t understand what is the fuss around the central government borrowing more. Also, with the GST in place, the ability of state governments to tax more is rather limited. Their main taxes on alcohol, real estate, petroleum products and vehicles, have already taken a huge beating this year.

4) It will be interesting to see the legal logic being used by the central government to take this stance. From what I understand, the GST Council and the central government are being considered separate entities (Maybe some lawyer can explain this in simple English).

5) If the state governments borrow from the market, how is it going to impact bond yields?

6) Also, the compensation cess on luxury and sin goods, will now have to be extended beyond 2022 and this will not go down well with businesses, which are already struggling.

7) There is bound to be in increase in compensation cess on some luxury and sin goods during this financial year. That remains the easiest way for the government to increase tax revenues. Also, I sincerely hope the GST Council doesn’t start increasing tax rates on normal goods in a bid to shore up revenues (Governments and government bodies have a tendency to do that).

Of course, the move hasn’t gone down well with state governments. Sushil Modi, the deputy chief minister of Bihar told this to the Press Trust of India, even before the GST Council meet: “It is the commitment of the central government to compensate the states for the shortfall in GST collections. It’s true that it is legally not binding on the Centre, but morally, it is.” Modi belongs to the BJP.

West Bengal finance minister Amit Mitra said: “The question is who should borrow. The Centre… can get a better rate and has more debt servicing capacity.” The finance minister of Delhi, Manish Sisodia, accused the Centre of “betraying” federalism by “refusing” to pay GST compensation to states.

As stated earlier, these options are only for 2020-21. What happens next year? With covid-19 pandemic continuing, the negative economic impact of this might be felt next year as well. The states have a week’s time to get back to the GST Council.

Of course, until then and even beyond, all the confusion will prevail. As I said, the entire scenario now looks like the last thirty minutes of a Priyadarshan movie, where everyone is going after everyone else, and no one knows what is actually happening. The irony is that this is in real life and not something to laugh at. But then when a government talks about an act of god to wriggle out of something that it clearly promised to many other governments, what else can one do anyway but laugh in pain.

There’s has got to be some difference between the government of the world’s largest democracy and an insurance company?