Everybody Loves a Good Interest Rate Cut…Except the Savers

My main life lesson from investing: self-interest is the most powerful force on earth, and can get people to embrace and defend almost anything – Jesse Livermore.

Late in the evening of March 31, the department of economic affairs, ministry of finance, put out a press release saying that the interest rates on small savings schemes for the period April to June 2021, have been cut.

The social media got buzzing immediately. And almost everyone from journalists to economists to analysts praised the decision. It was seen as yet another effort by the government to push down interest rates further.

With the state of the economy being where it is, lower interest rates are expected to perk up economic growth. People are expected to borrow and spend more. Corporates are expected to borrow and expand. At lower interest rates individuals who have already taken on loans will see their EMIs go down, leaving more cash in hand, and they are likely to spend that money, helping the economy grow.

That’s how it is expected to work, at least in theory. Hence, everybody loves a good interest rate cut… except the savers.

On April 1, the social media woke up to the finance minister Nirmala Sitharaman’s tweet announcing that “interest rates of small savings schemes… shall continue to be at the rates which existed in the last quarter of 2020-2021.” She further said that the order had been issued by oversight and would be withdrawn.

Later in the day, the department of economic affairs put out a press release to that effect.

The fact that lower interest rates are good for the economy is only one side of the story. They also hurt the economy in different ways. People who are dependent on interest income for their expenditure (like the retired senior citizens) see their incomes fall and have to cut down on their expenditure. This impacts private consumption negatively. 

While this cannot be measured exactly, it does happen. Also, a bulk of India’s household savings (close to 84% in 2019-20) are made in fixed deposits, provident and pension funds, life insurance policies and small savings schemes. Lower interest rates bring down the returns of all these products and this negatively impacts many savers.

As the economist Michael Pettis writes about the relationship between interest rate and consumption in case of China, in The Great Rebalancing:

“Most Chinese savings, at least until recently, have been in the form of bank deposits…Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”

The same logic applies to India as well, with lower interest rates being associated with declining consumption, at least for a section of the population.

This is not to say that interest rates should be higher than they currently are (that is a topic for another day), nonetheless the fact that lower interest rates impact savers and consumption negatively is a point that needs to be made and it rarely gets made. I made this point in a piece I wrote for livemint.com, yesterday. 

Also, borrowing is not just about lower interest rates. It is more about the confidence that the borrower has in his economic future and the ability to keep paying the EMI over the years. I wrote about this in the context of home loans, a few days back.

This leaves us with the question that why doesn’t anyone talk about the negative side of low interest rates. The answer lies in the fact that they don’t have an incentive to do so. Let’s try and look at this in some detail.

1) Fund managers: Fund managers love lower interest rates because it leads a section of the savers, in the hope of earning a higher return, to move their savings from bank fixed deposits to mutual funds and portfolio management services which invest in stocks. In the process, their assets under management go up. More money coming into the stock market also tends to push up stock prices.

All in all, this ensures that fund managers increase their chances of making more money and hence, they love lower interest rates because their acche din continue.

2) Analysts: Analysts love lower interest rates because it leads a section of the savers, in the hope of earning a higher return, to move their savings from bank fixed deposits to stocks. In order to buy stocks, they need to open a demat account with a brokerage. When the new investors buy stocks, the brokerage earns commissions.

Further, it also means that the interest cost borne by corporates on their debt goes down, leading to higher profits. The stock market factors this in and stock prices go up. Given this, analysts have an incentive to love interest rate cuts.

3) Corporates: Do I need to explain this? Lower interest rates lead to a lower interest outflow on debt that a corporate has taken on and hence, higher profits or lower losses for that matter. This explains why corporate honchos are perpetually asking the Reserve Bank of India to cut the repo rate or the interest rate at which it lends to banks.

4) Banks: Banks love lower interest rates simply because at lower interest rates the value of the government bonds they hold goes up. Interest rates and bond prices are inversely related. Higher bond prices mean higher profits for banks or lower losses in case of a few public sector banks. This is why bankers almost always come out in support of interest rate cuts.

This also explains why the bankers hate the idea of small savings schemes offering higher returns than fixed deposits. Lower interest rates on small savings schemes pushes the overall interest rates in the financial system downwards. 

5) Economists: Most economists are employed by stock brokerages, mutual funds, banks, corporates or think tanks. As explained above, stock brokerages, mutual funds, banks and corporates, all benefit from lower interest rates. If your employer benefits from something, you also benefit in the process. Hence, your views are in line with that.

When it comes to think tanks, many are in the business of manufacturing consent for corporates. Their economists act accordingly. 

6) Journalists: With the media being dependent on corporate advertising as it is, it is hardly surprising that most journalists love interest rate cuts. Further, the main job of anchors on business news channels is to keep people interested in the stock market because that is what brings in advertising. And this can only happen, if stock prices keep going up. In this environment, anything, like interest rate cuts, that drives up stock prices, is welcomed.

Of course, some mainstream TV news channels also run propaganda for the government. So, in their case every government decision needs to be justified. That is their incentive to remain in the good books of the government.

7) Government: The central government will end up borrowing close to Rs 25 lakh crore during 2020-21 and 2021-22. Hence, even a 1% fall in the interest rate at which it borrows, will help it save Rs 25,000 crore. It clearly has an incentive in loving low interest rates. 

The point is everyone mentioned above tends to benefit if interest rates keep going down or continue to remain low. Further, they are organised special interests with direct access to the mainstream media. The savers though many more in number aren’t organised to put forward their point of view.

Also, it is easier to do the math around the benefits of interest rate cuts and low interest rates than its flip side. As economist Friedrich Hayek said in his Nobel Prize winning lecture, there is a tendency to simply disregard those factors which “cannot be confirmed by quantitative evidence” and after having done that to “thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.”

That’s the long and the short of it. 

On Homes and Home Loans

Yesterday evening I had gone to meet a cousin who lives in the Western suburbs of Mumbai. All along the way, there were billboards of Kotak Mahindra Bank advertising its home loans, which are available at an interest rate of 6.65%.

While the interest rate of 6.65% comes with terms and conditions, such low interest rates have rarely been seen before. It is possible to get a home loan these days at an interest rate of 7%.

A few things have happened because of these low rates. There have been scores of stories in the media citing surveys where everyone from women to HNIs to NRIs to millennials seem to want to buy a house and they want to do it right here and right now. 

Of course, these surveys have been carried out by real estate consultants, whose very survival depends on the real estate sector doing well. Incentives as they say.

Low interest rates on home loans also have led to stories in the media suggesting that this is best time to buy a house. The other thing that has happened is that analysts have been recommending stocks of home finance companies (HFCs).

The logic being that at lower interest rates people will take on more home loans. This will help the loan book of HFCs grow, making them good investment bets. How easy all this sounds? But is it?

All this stems from the flawed assumption that people borrow more at lower interest rates and live happily ever after. Let’s see if that is true or not.

Take a look at the following graph. It plots the increase in home loans outstanding during the period April to January, over the years.

 Source: Author calculations on data from Centre for Monitoring Indian Economy.

What does the above graph tell us? It tells us that despite very low home loan interest rates, the increase in home loans given by banks between April 2020 to January 2021, stood at Rs 78,577 crore. This was around half of the increase of Rs 1,56,362 crore between April 2019 to January 2020.

Even between April 2018 and January 2019, the increase stood at Rs 1,46,227 crore. Clearly, people borrowed much more when interest rates were higher. Hence, the logic that people borrow more when interest rates are lower, basically goes for a toss.

In fact, the increase between April 2020 to January 2021, was the second lowest in six years in absolute terms. The lowest increase of Rs 74,837 crore was between April 2016 to January 2017. This period included demonetisation when banks had more or less stopped doing everything else and concentrated on taking back the demonetised notes from the public.

If we look at the period between April 2016 to October 2016, before demonetisation happened, the increase in home loans had stood at Rs 64,501 crore. Clearly the disbursal of home loans slowed down in the post demonetisation months.

There is another point that needs to be made here. Other than banks, HFCs or home finance companies, also give out home loans. Typically, banks give out two-thirds of the home loans and HFCs, the remaining third. Nevertheless, the last couple of years haven’t been good for a few HFCs. This has meant that some of the business of home loans has moved from HFCs to banks.

Once we take these factors into account then we can conclude that the increase in home loans during this financial year, has been the worst in six years. And this despite the extremely low interest rates. In percentage terms, the increase in outstanding home loans during this financial year has stood at 5.97%, the lowest in six years, and the only time the increase has been less than 10%. 

Why is that the case? For economists and analysts, the interest rate is the most important parameter that people look at while taking a home loan, nevertheless, a little bit of common sense tells us that this isn’t the case.

Let’s try and understand this through an example. As per HDFC, India’s largest HFC, their average home loan size is Rs 28.5 lakh. Their average loan to value ratio at the time of giving the loan is 70%. This basically means that HDFC on an average gives up to 70% of the price of the home as a home loan.

This basically means that the average price of a home in the books of HDFC against which they give a home loan, stands at Rs 40.7 lakh (Rs 28.5 lakh divided by 70%). Let’s round this to Rs 41 lakh, for the sake of convenience.

What does this mean? It means that in order to buy a home, other than taking on a loan of the buyer first needs to make sure that he has savings of around Rs 12.5 lakh (Rs 41 lakh minus Rs 28.5 lakh) to make the downpayment on the home loan. Even if the money is available, he or she needs to make sure that they are in a position to spend that money.

This is not where it ends. In many parts of the country a portion of the real estate transaction is still carried out in black. Money needs to be available for that. Further, a stamp duty needs to be paid to the state government. Then there is the cost of moving into a new house (everything from transport to perhaps new furniture).

Once we factor these things into account, we can conclude that the home loan forms around 50-60% of the overall cost of buying a house. Further, in a time like present, any individual thinking of buying a house will have to weigh the decision against the possibility of losing their job or facing a drop in income in their line of work.

Now let’s consider the average home loan of Rs 28.5 lakh. At 7% interest and a tenure of 20 years, the EMI on this amounts to Rs 22,096. At 9%, the EMI would have worked out to Rs 25,642. Hence, the EMI is Rs 3,546 lower.

So, yes, the EMI is lower. But what will the buyer first look at? The lower EMI or the ability to be able to pay the lower EMI and be able to continue paying it in the days to come. Of course, the buyer will look at his ability to pay the EMI and be able to continue paying it. Also, it needs to be remembered that the interest rate on the home loan is a floating one, and can rise in the years to come.

Hence, this decision will be based on the confidence that the buyer has in his or her own economic future. This is not something that can be measured at an aggregate system level and varies from buyer to buyer. The point being that everything that is important cannot necessarily be measured in numerical terms.

Having said that, the confidence in the economic future will be currently low, with many individuals losing their jobs or seeing their friends, relatives and acquaintances lose jobs. Hence, other than losing a job, there is also the fear of losing the job. There has also been a drop in their income or in some cases small businesses have been shutdown. 

Also, whether it is the best time to buy a house or not, like most things in personal finance, it depends on your finances and more importantly your mental makeup of what you want from life. If you want to settle in life and make your parents and relatives happy, and have the money to do so, then now is as good a time as any to buy a home.

Please keep this in mind at every point of time in life when some expert tells you that this is the best time to do this or the best time to do that.

So, right now if you think you have enough money and enough confidence to keep paying the EMI, and want a home to live in, then please go ahead and buy one. Also, make sure that you have enough savings to pay the EMI for at least six months to a year, even without your main source of income.

To conclude, buying a home is not just about low interest rates. There are several other factors, which people who are in the business of selling real estate, seem to conveniently forget about.

Then there are surveys in which a high proportion of people end up saying they want to buy a home to live in. Of course, they do. But just wanting to do something doesn’t add to demand. I mean, I want to buy a house in central Mumbai, but I also know that ain’t going to happen. My finances don’t allow it.

Vehicle Scrapping Policy is Half-Baked and More About Feeding a Constant Narrative

Late last week the central government announced the vehicle scrapping policy (VSP). As the Minister for Road Transport and Highways, Nitin Gadkari, put it in the Parliament, the aim of the VSP is to create “an eco-system for phasing out of unfit and polluting vehicles”.

So how will this be put into action? Using the public private partnership (PPP) model involving the state governments, private sector and the automobile companies, the central government plans to promote the setting up of automated fitness centres (AFCs). 

These AFCs will issue vehicle fitness certificates to private vehicles and commercial vehicles based on emission tests, braking, safety equipment among many other tests which are as per the Central Motor Vehicle Rules, 1989.”

A commercial vehicle which is 15 years old and fails the vehicle fitness test will be declared an end of life vehicle and scrapped. Similarly, a private vehicle which is 20 years old and fails the vehicle fitness test will be declared to be an end of life vehicle and scrapped. Further, if owners don’t renew the registration certificate, their vehicle may be declared as an end of life vehicle and scrapped.

In order to disincentivise commercial vehicle owners who own vehicles which are 15 years old, from continuing to use them, even if they clear the vehicle fitness test, the fee for the fitness certificate and the fitness test will be set on the higher side. For private vehicle owners with vehicles which are 15 years old, the re-registration fee will be set on the higher side.

The point being that if you have a private vehicle which is 20 years old or perhaps even older, the government wants you to stop using the vehicle and buy a new one, irrespective of what state it is in. For commercial vehicles, the same logic applies for vehicles which are at least 15 years old.

And the expectation is this will lead to lower pollution, newer cars, safer pedestrians, more spending, more investment and more jobs. QED.

The minister expects additional investments of Rs 10,000 crore and 35,000 job opportunities to be created because of this.

It will also lead to banks and non-banking finance companies (NBFCs) giving out more loans. Of course, given that the auto industry and the auto-ancillary industry use a lot of contract workers, one could possibly argue that this could lead to more work opportunities for them as well. 

The question is how will things really play out? Let’s try and understand that in some detail.

Economics is basically the study of incentives and second order effects. The trouble is that politicians and policy makers don’t keep this in mind while designing policy, particularly the second order effects of what they are proposing.

Let’s try and understand this pointwise.

1) There are a total of 1.02 crore vehicles, both commercial and private, which fall under the defined category of older vehicles. Even if a small proportion of these vehicles are scrapped they will generate a huge amount of non-biodegradable waste.

What plans do we have to handle all this waste coming our way? As the press release announcing the policy pointed out: “Efforts are also being made to set up Integrated Scrapping Facilities across India.” Even while taking into account that this policy will be implemented over the next few years, this sounds too much like work in progress than definitive economic policy. One needs a lot more clarity on this front. 

2) As a way to get the scheme going, the government first plans to scrap its older vehicles. As the press release announcing the plan puts it: “It is being proposed that all vehicles of the Central Government, State Government, Municipal Corporation, Panchayats, State Transport Undertakings, Public Sector Undertakings and autonomous bodies with the Union and State Governments may be de-registered and scrapped after 15 years from the date of registration.” This is supposed to be implemented from April 1, 2022 onwards, or little over a year from now.

Why have this blanket policy at a time when governments, in particular state governments, are already short of money? Why not look at the fitness of vehicles and then decide? If at all, vehicles of the central government and the public sector enterprises tend to be decently maintained.

3) Also, the assumption here is that only older vehicles cause pollution. The manufacturing of newer vehicles needs electricity. Most electricity in India is generated by burning coal, which causes pollution. Steel goes into the making of vehicles. The process of making of steel, releases carbon dioxide into the atmosphere. That causes pollution as well. The same is true of plastic and pretty much everything else which goes into the making of vehicles. Hence, every new vehicle that is produced has a carbon footprint. 

Of course, all this pollution doesn’t show up in cities where most private vehicles are driven and tends to be well distributed across the country. But shouldn’t a policy that has lower pollution as one of its key points, take this basic factor into account as well? Further, we need to consider the fact that many older private vehicles are not constantly in use. 

4) As I have explained earlier, the government wants private and commercial vehicle owners to buy new cars. Of course, as and when this happens, the automobile companies are supposed to benefit. This explains why companies have come out in favour of this policy (or even otherwise, when do Indian businessmen ever disagree with the government). But this doesn’t take a very basic factor into account.

Whatever we might like to say about the new India and such things, we are a poor country at the end of the day. And covid has only made things even more difficult by pushing many more people into poverty, as health bills have mounted, incomes have crashed and small businesses have gone bust.

Hence, assuming that people will go out and buy new vehicles if the older vehicles are scrapped or because re-registration is made more expensive, is just looking at first order effects of policy, in the same way that economists tend to believe that lower interest rates always push up consumption. 

Private vehicle owners who are not heavy users of their vehicles, might just prefer to use Uber or Ola or even the metro infrastructure coming up across India’s major cities. (This reminds me of a time when the government kept telling us that slower automobile sales were primarily because of Uber and Ola).

Further, owners might financially not be in a position to buy a new vehicle. Already, the trucking industry has spoken up against the idea.

Also, even if owners buy a new vehicle, they might cut consumption on something else given that there is only so much money going around. Hence, net-net, the impact on the overall economy may not be much.

The trouble is that the costs of second order effects are not so obvious and straightforward, whereas the supposed benefits are easy to convey in a simplistic way. And politicians love stuff which they can convey in a simplistic way.

5) Kitna deti hai (how much does it give?), goes a Maruti advertisement, telling us that Indians are price conscious value for money consumers. And there is nothing wrong with this, given that an automobile is probably the second most expensive thing we buy during our lifetime. So, while the idea that old polluting vehicles need to be discarded is a noble one, what is in it for the consumer?

This is what the government is planning. a) The owner will be paid 4-6% of the showroom price of a new vehicle, when his old vehicle is scrapped. b) The state governments may be advised to offer a road- tax rebate of up to 25% for personal vehicles and up to 15% for commercial vehicles. c) The vehicle manufacturers are also advised to provide a discount of 5% on purchase of new vehicle against the scrapping certificate. d) The road transport minister has requested the finance minister and states to give a concession in goods and services tax (GST) on purchase of new vehicles.

There are too many ifs and buts in the above paragraph. As usual, the government seems to be in a hurry to announce and implement a policy. As I have said in the past a massive cut in GST on automobiles will encourage buying. What the government will lose out on per unit of sales, it is more than likely to make up for through volumes. 

One understands that the road transport minister cannot ensure all of this on his own, which is why it is important that the government spends some time in discussing and figuring out how to design and implement policy. Also, it is important to carry out small experiments in union territories, before announcing policies which need to be implemented across the length and the breadth of the country.

As Vijay Kelkar and Ajay Shah write In Service of the Republic

“The safe strategy in public policy is to incrementally evolve—making small moves, obtaining feedback from the empirical evidence, and refining policy work in response to evidence.”

But the trouble is that small moves involve a lot of time, effort and thinking, which is very difficult for a government which believes in constant action and constantly creating new narratives to keep people busy and happy. The narrative also feeds into the idea that the government is trying to do new things. 

6) Take a look at what happened to two-wheeler sales in 2019-20 (This is before covid struck). Sales fell by nearly 18% year on year to 17.42 million units, as the price went up due to various reasons. Hence, India is a very price sensitive market and the point is that there has to be a huge benefit involved in buying a new vehicle in a tough economic environment.

While the notion of pollution control is a noble one, it is not something which is going to get people to go out and buy new vehicles, unless it is very clear what is in it for them. Ultimately, if you want people at large to behave in a certain way, the right incentive should be on offer, something this half-baked policy, like the policy to encourage electric vehicles before it, lacks.

To conclude, one does wonder, what were they doing all these years, given that the policy has been on the anvil for a while now. 

India, China and the Quest for Atmanirbharta

Atmanirbharta has been the hot political and economic buzzword in India for quite a while now. It means self-reliance in English. Or as the finance minister Nirmala Sitharaman put it in her budget speech:

“Atmanirbharta is not a new idea. Ancient India was largely self reliant, and equally, a business epicentre of the world. Atmanirbhar Bharat is an expression of 130 crores Indians who have full confidence in their capabilities and skills.”

In economic terms it essentially refers to import substitution, which India practiced for almost four decades, after independence, where the idea was to make everything in the country rather than import it.

In political terms, the narrative is directed towards China and our import dependence on the Middle Kingdom. In the recent past, our political tensions with our largest neighbour have escalated and we are trying to hurt it economically by producing more at home, and not importing as much from it as we had done in the past. Also, we have banned many Chinese apps.

The question is where are we going with atmanirbharta. Let’s take a look at the following chart, which plots the total amount of goods imported from China during the period April to January, over the years.

Source: Centre for Monitoring Indian Economy.

The goods imports from China during the current financial year have been the lowest between 2016-17 and 2020-21, at $51.92 billion. Nevertheless, a simple presentation of goods imports doesn’t take into account the fact that India’s goods imports during April 2020 to January 2021 have fallen by 23.1% to $340.9 billion. They stood at $443.22 during April 2019 to January 2020. This fall shows a lack of consumer demand, which has crashed during the course of the year, with the spread of the covid pandemic.

Let’s look at the next chart, which plots what proportion of India’s goods imports came from China, during the period April to January of a financial year, over the years.

Source: Author calculations on data from Centre for Monitoring Indian Economy.

During April 2020 to January 2021, the proportion of imports coming from China stood at 15.23%. This is the highest in the period considered. Hence, while economic and political narrative maybe moving towards atmanirbharta, the data clearly shows something else. Our dependence on China for goods imports continues, like it was in the past.

There is one more way we can look at data. While we don’t have the full year’s data for 2020-21, we do have that for the years gone by. Hence, we take a look at proportion of full-year imports coming from China, in the next chart.

Source: Centre for Monitoring Indian Economy.
*April 2020 to January 2021.

The above chart makes for a very interesting read. In 1991-92, India barely imported anything from China. Just 0.11% came from China. In the nearly three decades that have followed, the imports from China have exploded. This just shows the rise of Chinese productivity year on year, in comparison to that of India. The proportion of imports coming from China peaked at 16.4% in 2017-18, fell for the next two years, and have risen again this year.

What is the reason for this marginally increased dependence in 2020-21? Ananth Krishnan writing in his terrific book India’s China Challenge – A Journey Through China’s Rise and What It Means for India, quotes Amitendu Palit, an economist at the National University of Singapore, in this context.

As Palit says: “If you look at critical medical supplies, which India has been importing for frontline healthcare workers in the Covid-19 battle, most of these come from China, which is one of the top sources, but, on the other hand, there isn’t a very widely diversified source of countries from which India can actually import these either.”

The larger point here is that China has now become central to many global supply chains and hence, it won’t be easy for India to lower its dependence on China dramatically as far as imports of goods is concerned.

In fact, one area where India has managed to reduce its dependence on China in the last five years, is telecom instruments, as they are categorised in the imports data. Given that the use of landline phones has come down over the years, the category  primarily includes mobile handsets.

Take a look at the following chart. It plots the value of the telecom instruments (read mobile handsets) imported from China, over the years.

 Source: Centre for Monitoring Indian Economy.
*April 2020 to January 2021.

As can be seen, the value of the instruments imported from China has come down over the years, though the 2020-21 full year imports are likely to end up being higher than those in 2019-20. In 2017-18, import of telecom instruments formed a little over a fifth of our imports from China. This fell to 8.67% in 2019-20 and has increased to 10.48% in the current financial year.

To make companies manufacture mobile phones in India, the government has been imposing duties/tarrifs on various goods that go into making of a mobile phone. The idea is to make imports from China expensive and in the process, force companies to manufacture phones in India.

In fact, this strategy has been borrowed from China. As Matthew C Klein and Michael Pettis write in Trade Wars and Class Wars: “Import substitution has succeeded thanks in part to Chinese government policies that have systematically encouraged Chinese businesses to substitute foreign production for domestic production, even when this has raised costs for Chinese consumers.” Of course, unlike India, China does not need to impose duties/tariffs to “direct domestic demand towards domestic production”.

As Klein and Pettis point out: “Executives can simply be told to pick Chinese suppliers over foreign ones… The result is that, unlike many other countries, imports have become less and less important to the Chinese economy since the mid 2000s.”

Also, given that Indian productivity is worse than that of the Chinese, manufacturing in India, comes with a cost. While, mobile handset prices barely rose between 2015 and 2019, the same hasn’t been the case in 2020, when they rose by 7%. Clearly, the cost of atmanirbharta on the mobile handsets front is being borne by the Indian consumer. As I keep saying, there is no free lunch, someone has got to bear the cost.

The government has also come up with the production linked incentive (PLI) scheme in order to help manufacturing companies in India. As Sitharaman said in the budget speech:

“Our manufacturing companies need to become an integral part of global supply chains, possess core competence and cutting-edge technology. To achieve all of the above, PLI schemes to create manufacturing global champions for an Atmanirbhar Bharat have been announced for 13 sectors. For this, the government has committed nearly Rs 1.97 lakh crores, over 5 years starting FY 2021-22. This initiative will help bring scale and size in key sectors, create and nurture global champions and provide jobs to our youth.”

There are multiple problems with this approach. The first being that the government is trying to pick winners. This entire approach smells of how things used to happen before the economic reforms of 1991, with the bureaucrats deciding what businesses should be doing.

Also, this comes at a time when prime minister Narendra Modi has been critical of IAS officers. As he said in February: “Just because somebody is an IAS officer, he is running fertiliser and chemical factories to airlines.” The same babu is now expected to run an incentive scheme for big business.

India’s biggest success stories over the last three decades, software, pharma and automobiles, happened despite the government, and not because of it. So, the idea still should be to make things easier for smaller businesses to grow bigger, which is something that happened beautifully in the IT sector. (This is not to say that the government didn’t help. It did. But it largely didn’t meddle).

In fact, while we think of China as a country with big companies that wasn’t always the case. China’s initial growth in the 1980s and up until the mid 1990s was through the growth of millions of Township and Village Enterprises (TVEs). This is a fact that seems to have been forgotten.

Big companies growing bigger can create some jobs, but not the number of jobs that India requires. As data from the Centre for Monitoring Indian Economy shows, in the last five years India has added 11.77 crore individuals to the working age population.

This means that around 19.76 lakh individuals have crossed the age of 15 on an average every month, over the last five years. Of course, not all of them are looking for jobs but a good chunk are. Even if we assume that around 40% of them are looking for jobs, we end up with around one crore people looking for jobs every year.

Such a huge number of jobs can only be created by small businesses growing bigger and not by big businesses growing bigger, which can only possibly be the icing on the cake.

As an OECD (Organisation for Economic Co-operation and Development) research paper points out:

“SMEs (small- and medium-sized enterprises) account for 60 to 70 per cent of jobs in most OECD countries, with a particularly large share in Italy and Japan, and a relatively smaller share in the United States. Throughout, they also account for a disproportionately large share of new jobs, especially in those countries which have displayed a strong employment record, including the United States and the Netherlands. Some evidence points also to the importance of age, rather than size, in job creation: young firms generate more than their share of employment.”’

In fact, given the obsession the current government has had with scale and formalisation of the economy, small businesses have been hurt through a mind-numbing move like demonetisation and a half-baked goods and services tax.

Further, the globalisation game itself might be changing. While, we might want companies based out of India to become a part of global supply chains, it is worth remembering here that the strategy worked at a certain point of time.

As Krishnan writes:

“China was able to recognize and exploit the opportunities just as global production chains were forming through the opening of the early 1990s… The infrastructure it was able to create through the 1990s enabled ‘a unique and probably unrepeatable combination of low developing country labour costs and good, almost rich country infrastructure.'”

Also, the supply chains that are already in place are not going to shut down and move to India, just because India is now offering incentives. As Apple CEO Tim Cook said in 2017: “The popular conception is that companies come to China because of low labour cost… The reason is because of the skill, and the quantity of skill in one location and the type of skill it is.”

India clearly has a skills problem. A little more than a fifth of Indian graduates are unemployed, and at the same time when companies advertise for personnel, they can’t seem to find enough of them who meet the right criteria. Multiple surveys have found Indian graduates and engineers to be simply unemployable. This is not something that can be set right overnight.

The corporates, not surprisingly, have welcomed the scheme, given that the government is offering “a recurring cash subsidy computed as a fixed percentage of the manufactured sales turnover.” Hence, they clearly have an incentive to do so. In fact, lobbying has already started on this front.

Take the case of the PLI scheme in the electronics and mobile manufacturing, which has been touted as a success, after attracting investments of over Rs 11,000 crore in 2020. As an editorial in The Hindu Business Line points out, the beneficiaries are already asking for a rollover, “citing land acquisition delays, lack of skilled workforce and demand issues post Covid.”

Also, as has been seen in India in the past, once a subsidy is introduced into the government’s budget, it rarely goes away.

Finally, lest I be accused of looking at only negatives (honestly, please go to news.google.com and enter PLI scheme, you will only get positive stories to read), one positive thing could come out of the scheme.

As Palit told Krishnan in the context of China: “When we look at value chains today, let’s say in a post Covid-19 situation, the emphasis on the part of businesses is to make these chains shorter, more resilient, more durable, and locate them closer to demand markets… This is where we often overlook the importance of China. It continues to remain a major source of final demand.” And given this shifting supply chains out of China will be difficult.

This applies to India as well. Given India’s size, it will continue to have a huge source of consumer demand in the years to come. This should encourage companies looking for stable supply chains to have their manufacturing bases in India to cater to its domestic market. And this is where PLI can work its magic.

As Neeraj Bansal of KPMG put it in a recent writeup:

“From raw materials to critical components, the COVID-19 pandemic exposed the reliance of country’s key sectors on a few markets for fulfilling their manufacturing and sourcing requirements. To put things in perspective, India depends on a single market for 70 per cent of its API consumption needs, 85 per cent of smartphone components imports and 75 per cent of television components imports. As global supply chains were swiftly and effectively dismantled as one country after another went into lockdown in 2020, efforts toward bolstering domestic manufacturing gained momentum.”

Nevertheless, there is a corollary to this. As more and more people get vaccinated and the world moves on and goes back to doing things that it always has, this narrative of having manufacturing facilities closer to the demand markets, will keep getting weaker. Hence, India has a couple of years to cash in on it.

Of course, whether India emerges as a country where the products are assembled or major value addition takes place, remains to be seen. Also, prices will go up. Make in India will come at a cost.

Why a Billionaire Tax Doesn’t Make Any Sense for Politicians

Incentives.

In the end everything boils down to it.

In the run up to the annual budget of the union government presented by the finance minister Nirmala Sitharaman, on February 1, many economic commentators suggested that the government should resort to a one-time billionaire tax.

The idea being that the stock market has rallied big time during the course of this financial year. Hence, while the income of the average Indian has fallen thanks to the economy contracting, the super-rich have become richer.

This one-time tax could fund a lot of extra expenditure in the budget in 2021-22, as the government tried to act as the spender of the last resort in an environment where private spending has slowed down and industrial expansion isn’t happening at the same pace as it was.

If you are the kind who practices first level kind of thinking, this makes perfect sense. The rich have grown richer. So, let’s take money from them and give it to those who need it. It also leads to greater equality, at least in your head. This kind of Robinhood thinking has prevailed for centuries. Hence, there is no reason for it to go away in 2021.

Nevertheless, if you are the kind who practices second level thinking and at the same time thinks about the incentives on offer, you would know that something like this doesn’t make sense and is also unlikely to happen.

Let’s try and understand this pointwise.

1) It is important to understand that billionaires don’t have cash lying around to pay this tax. So, one way they would have raised cash to pay this tax would have been to sell some of their shares. Of course, given the sudden increase in supply of shares in the market could have led to the stock prices falling.

2) Actually, more than the billionaires selling their stake to pay up the tax, the stock market would have seen this move of the government in a negative way and sold off, even before billionaires would have started thinking about how to pay the tax. In fact, in the run up to the budget, the stock market did worry about new taxes and there was a sell off last week. This was its way of telling the government, please, no new taxes. It has been rising this week, since it realized that no news on the tax front is good news.

3) Currently, the government needs the stock market on its side, with its plans to raise Rs 1.75 lakh crore through the disinvestment route next year. And that is only possible if the stock prices continue to remain at high levels. Hence, it would have made no sense for the government to disturb the status quo. If the market would have fallen, it would have impacted the ability of the government to raise the amount of money it wants to through disinvestment. This would have, in turn, impacted its ability to spend.

4) These were the near-term reasons. But there are more issues at play here. Most Indian billionaires finance political parties both on record and off record. In their eyes they are already paying a billionaire tax. A lot of this money finds its way into the economy and is spent, during election time. In that sense, billionaire money is pump priming some part of the Indian economy all the time, given that elections to state governments happen every year.

Of course, no billionaire does this as a social service. They are looking for a quid-pro-quo from the government. That needs to be kept in mind as well.

5) It’s important to look at this entire idea from the point of view of the incentive at play for a politician as well. Politicians exist to win elections. For this they need money, a massive amount of it. They can’t win elections by spending money within the limits set by the Election Commission. Where does this money come from? To a large extent from billionaire businessmen who operate in spaces where they need to deal with government all the time. Hence, why would any politician in his or her right mind try to disturb this equation by irritating the main funders through a high one-time income tax. It just doesn’t make any sense.

6) Finally, a high-income tax, one-time or otherwise, is always a bad idea. One it leads to a narrative of inconsistent tax policy, which the Indian government anyway suffers from. Two, it also leads to high income earners, who can leave the country to leave the country, and move to tax havens. The highest income tax rate in the country currently is greater than 40%. Hence, not surprisingly, a whole bunch of high-income earners have moved or want to move to places like Dubai. This obviously means they no longer pay their income tax in India.

Given these reasons a billionaire tax didn’t make any sense. Having said that, there is a case for clear rationalization of tax rates that is needed. You can’t have a small proportion of the salaried paying the highest marginal rate of more than 40% or even 30%, whereas those who can use the benefit of indexation while paying income tax, not paying any tax at all or a very low rate of tax. This needs to be corrected.