Tag: Jim Walker | Vivek Kaul

The finance minister Arun Jaitley has been at the forefront in trying to defend the demonetisation or notebandi decision of the Modi government.

He recently said in London: “Demonetisation was a move to change the Indian normal… a new normal had to be created. A predominantly cash economy has now to be substituted with a digital economy, which will bring more money into the banking system and lead to better revenue generation; the integration of the informal economy with the more formal one is now taking place… The post-demonetisation regime is actually going to generate a far bigger GDP in the long run.” He also said that the arguments being made in favour of the cash economy were absolutely trivial.

There is much that is wrong with the above statement, but in this column, I would like to just concentrate on the part that I have marked in red in the above paragraph. Before we get into anything else it is important to define the meaning of the term “informal economy”. Here is a basic definition. It is that part of the economy which is not really monitored by the government and hence, it is not taxed. But there are several nuances to this as well, which we shall see during the course of this column.

In Jaitley’s binary world, the formal economy is good because it brings in tax to the government, and the informal economy is bad, because it does not bring in tax to the government. Demonetisation has managed to create a cash shortage which Jaitley believes will force a large section of the informal economy to move towards becoming formal and allow the government to tax them.

The trouble is economics is never so straightforward. As economist Jim Walker of Asianomics wrote in a research note: “There is nothing intrinsic that says that the informal economy is a less effective or beneficial source of activity than the formal economy.” Allow me to elaborate on this.

Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital wrote in a recent research note: “India’s informal sector is large and labour-intensive. The informal sector accounts for ~40% of India’s GDP and employs close to ~75% of the Indian labour force.” The point is that the informal sector forms a significant portion of India’s economy and employs three fourths of India’s workforce. There are other estimates which say that the informal sector employs more than 75 per cent of India’s workforce.

Hence, notebandi has ended up disturbing 75 per cent or more of India’s labour force. The cash crunch that has followed has severely disrupted the informal sector. As Mukherjee and Shekhar write in a recent research note: “Panipat in Haryana is the textile hub of North India. It is a ~Rs 31,000 crore industry with Rs 60,000 crore worth of goods being exported. It employs ~350,000 labourers. Whilst our interviews suggested that the export-focused units were largely unaffected, the domestic component of the industry saw business fall by 40-80% as this component of the business is more cash-reliant. As a result, almost half of the 350,000 labourers employed in the region have been temporarily laid off as demand has collapsed in the domestic market and there is no cash to pay the wages.” Similarly, in Tirupur, another textile hub, “the units are running only three days a week (compared to 7 days before demonetisation) due to the lack of demand,” the analysts point out.

This is something that cannot and should not be taken lightly. Jaitley in his London speech said that notebandi will lead to better revenue generation for the government. This means that the government will end up collecting more taxes.

The assumption here is that informal sector does not pay taxes. This is not totally correct. As I said the argument is slightly more nuanced than this. As I write in my new book India’s Big Government-The Intrusive State and How It is Hurting Us: “The National Manufacturing Policy of 2011 estimated that the number of Small and Medium Enterprises (SMEs) in India stood at over 26 million (2.6 crore) units. They employed around 59 million (5.9 crore) people. This means that any SME, on an average, employed 2.27 individuals. The Boston Consulting Group estimated that 36 million (3.6 crore) SMEs (or what it calls micro-SMEs) employ over 80 million (8 crore) employees. This means that any SME, on an average, employs 2.22 individuals.”

What this clearly tells us is that the size of an average Indian SME is small, in fact, very small and it is a part of the informal sector. They employ around 2.2-2.3 individuals on an average. These firms basically employ the owner and one more person, on an average. Interestingly, nearly two-thirds of these firms are own-account enterprises without any hired workers.

The contention is that these people who are a part of the informal economy do not pay any taxes, this includes income tax. The question is do they need to pay an income tax? Let’s look at some data. Take a look at Figure 1. It shows the money being made by different categories of people.

Figure 1:

Take a look at the self-employed (remember two-thirds of small and medium enterprises in India are own-account enterprises without any hired workers). 96 per cent of self-employed earn an income of up to Rs 2,40,000 per year. Individuals come under the tax bracket only if they earn more than Rs 2,50,000 lakh per year.

Almost 100 per cent of the casual labour which works in the informal sector earns an income of up to Rs 2,40,000 per year. Hence, a major part of the individuals who work in the informal sector do not need to pay income tax. Given this, even if the government was in a position to collect income tax from these individuals, it wouldn’t be able to do so. The point being informal economy does not necessarily mean black economy.

Also, it is worth mentioning here that when these individuals who form a bulk of the informal economy spend the money they earn, they do pay indirect taxes which are built into the products being sold. Over and above this, the money they spend is an income for companies and individuals who are a part of the formal economy and pay income tax. Long story short-the situation is not as simplistic as Jaitley wants us to believe.

Having said this, it does not mean that the entire informal sector is kosher. There are individuals and enterprises who need to pay tax but they aren’t. It is these individuals and enterprises that the income tax department should be going after.

Also, more revenue for the government and going cashless doesn’t necessarily mean a good thing. As Walker puts it: “There is every reason to worry about the fact that moves towards a cashless economy will benefit banks (transactions cost) and governments (more taxes). The apologists for demonetisation were keen on the fact that it might prove to be an easier way for government to collect revenues. Governments come and governments go and one thing is for sure, they do not all spend money wisely. Giving them more access to individuals’ money is demonstrably not unequivocally a ‘good thing’.”

And that is something worth thinking about.

The column originally appeared on Equitymaster on March 2, 2017

In 2015, China grew by 6.9%. This is the slowest the country has grown in more than two decades. For a country which has been used to growing in double digits for a very long time, an economic growth rate of 6.9% is very low. Further, there are many economists who believe that even the 6.9% number isn’t correct.

A recent report in the Wall Street Journal quotes, an economics professor Xu Dianqing, as saying “that China’s gross domestic product growth rate might just be between 4.3% and 5.2%”.

The Chinese manufacturing sector which makes up for 40.5% of the economy grew by 6% in 2015. Nevertheless, many underlying indicators like power generation, railway freight movements, steel, cement and iron output, paint a different picture. As the Wall Street Journal points out: “Of some 60 major industrial products, nearly half saw output contract in the January to November period, while railway cargo volume fell 11.9% for all of last year, according to official sources.” (Doesn’t this sound similar to what is happening in India as well?)

Given this, it is only fair to ask how did the Chinese manufacturing sector grow by 6% in 2015? And how did the overall economy grow by 6.9%?

The point being that China is not growing as fast as it was and not as fast as it claims it is. Of course, if economists outside the government can figure this out, the government obviously realises this. Nevertheless, like all governments they need to maintain a position of strength and try and revive a flagging economy.

In the world that we live in, economists and politicians have limited ideas on how to tackle an economy that is slowing down. The solution is to get people to borrow and spend more. In a country like China where the government controls large parts of the economy, it means encouraging banks to lend more.

And that is precisely what has happened. In January 2016, responding to the low economic growth in 2015, the Chinese banks gave out loans worth 2.5 trillion yuan or around $385 billion. This is “a new record for a single month!” point out Dr Jim Walker and Dr Justin Pyvis of Asianomics Macro.

To give you a sense of how big the lending number is, let’s compare it to what the scheduled commercial banks in India lent during a similar period. Between January 8 and February 5 2016, the Indian banks loaned out around Rs 72,580 crore or $10.6 billion, assuming that one dollar is worth Rs 68.7. The way RBI declares lending data of banks, it is not possible to figure out how much the banks lend during the course of any month and hence, I have picked up the nearest comparable period.

The Chinese banks lent around 36 times more than Indian banks during a similar period. Of course, the Chinese economy is bigger than India is one factor for this difference.

A number of explanations have been offered for this huge jump in Chinese lending. One is the revival of the Chinese property sector. Further, with the yuan depreciating against the dollar in the recent past, many Chinese companies are replacing their dollar debt with yuan debt, in order to ensure that they don’t have to pay more yuan in order to repay their dollar loans in the future.

But these reasons clearly do not explain this huge jump in lending. Chinese banks are lending out so much money because the government wants them to increase their lending dramatically.

The idea, as always, is to get people to borrow and spend money, and companies to borrow and expand, and in the process hope to create faster economic growth. The trouble is that all this borrowing and spending will only add to the excess capacity that already exists in China.

As Satyajit Das writes in The Age of Stagnation: “It would take decades for China to absorb this excess capacity, which in many cases will become obsolete before it can be utilised. Yet China continues to add capacity to maintain growth.”

Further, the credit intensity or the amount of new debt needed to create additional economic activity has gone up in China, over the years. As Das writes: “The incremental capital-output ratio(ICOR), calculated as the annual investment divided by the annual increase in GDP, measures investment efficiency. China’s ICOR has more than doubled since the 1980s, reflecting the marginal nature of new investment. China now needs around $3-5 to generate $1 of additional economic growth; some economists put it even higher at $6-8. This is an increase from the $1-2 needed for each dollar of growth 8-10 years ago, consistent with declining investment returns.”

The point being that China now needs more and more money to create the same amount of growth. And this means the effectiveness of borrowing in creating economic growth has come down over the years. This also means that the chances of money that the banks are lending out now, not being returned, is higher now than it was in the past.

In fact, as Walker and Pyvis of Asianomics Macro point out: “The China Banking Regulatory Commission reported that official nonperforming loans had jumped 51% year to 1.3 trillion renminbi [yuan] by December, now greater than at the last peak in 2009. While small in terms of the total number of loans out there – the bad loan ratio increased from just 1.25% to 1.67% – it is the direction that is bothersome, particularly given the well-publicised concerns over the accuracy of the data (hint: NPLs are much higher than 1.67%).”

Further, the Reuters reports that the special mention loans (loans which could turn into bad loans or what we call stressed loans in India), rose by 37% in 2015. And bad loans and special mention loans together form around 5.5% of total lending by Chinese lending. Indeed, this is worrying.

This huge increase in lending will obviously push up the economic growth in the short-term. But in the long-term it can’t be possibly good for the economy, as it will only lead to the non-performing loans going up and creation of many useless assets which the country really does not require. The current jump in bad loans of banks happened because of the huge jump in bank lending that happened in 2009, after the current financial crisis started.

Whatever happens, in the short-term, the era of “easy money” seems to be continuing in China. And that can’t possibly be a good thing.

The column originally appeared on the Vivek Kaul’s Diary on February 22, 2016.

Mr Jaitley, Informal Economy Doesn’t Necessarily Mean Black Economy

China Unleashes Another Round of Easy Money