RBI’s macroeconomic policy trilemma

The monetary policy committee in the recently held meeting decided to keep the interest rates unchanged. Many economists have expressed apprehension that the RBI is facing the classical macroeconomic trilemma. This article attempts to simplify this economic jargon.

The macroeconomic trilemma is the result of Mundell Fleming model which states that an independent monetary policy, a flexible capital account, and a fixed exchange rate is not possible simultaneously.

The commercial banks are entangled with excess liquidity as a result of demonetization. The RBI attempted to mop out the excess liquidity through its open market operations.  However, it decided to suspend its open market sale on November even when the Moody’s revised its ratings. This attributes to the macroeconomic trilemma being faced.

The government yields had crossed 7 %. Had the RBI continued with its open market sales it would have increased the yields further. (Note that yield and price of bonds are inversely related to each other. The higher is the yield, riskier is the security.)

The increased yield would have invited capital flows and appreciated the rupee.

The economy is already mired with rupee appreciation. To avoid further appreciation, RBI might then have to undertake open market purchases of security, thus reversing the initial independent monetary policy of open market sales.

Though India has a partially convertible capital account and managed exchange rate, the application of Mundell Fleming model is still phenomenal.

How much Good and Simple is the present the GST?

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When the clock struck 12 on 30 June 2017, India stepped into long awaited One Nation One Market through implementation of Goods and Services Tax (GST). GST came into effect by 101^st Constitutional Amendment Act following the passage of 122^nd Constitutional Amendment Bill. It is hailed as a Good and Simple Tax because of emphasis on minimising the cascading effects of tax, rationalising tax structures, improving tax compliance and thus aiming at improving the ease of doing business.

Having said that the 101^st amendment has undoubtedly opened a new chapter in India’s economic history, the present GST has certain drawbacks too. The shortcomings of GST can be broadly classified into complexity of tax structures, problem of tax compliances and technical glitches.

1)      Complexity of Tax Structures

GST was envisaged as a Good and Simple Tax but the present tax structure with five different rates and cesses is far away from being simple. There have been reports about how milk has been subjected to different rates. However, it merits attention that this problem is ought to occur in a country which is hostage to huge income inequality. Thus the trade-off is actually between having a good tax (which in my view is a tax which takes into consideration the impact of tax burden on different segments of the society) and a simple tax (which is to approach towards a unified tax rate as close as possible).

Given the fact that only about half of the Indian economy comes under the ambit of GST, the items subjected to GST have mostly been taxed stiffly. India has one of the highest tax rates in GST in the world. Further imposition of cesses goes against the principle of Value Added Taxation. Interestingly, the state finance ministers don’t have much objection to distorted tax structures and its repercussions on growth because of the Compensation Scheme. However, there is optimism that when the tax buoyancy improves the tax rates will be slashed.

2) Compliance Problem

The tax compliance has become major hurdle particularly for MSMEs. In the earlier tax regime, entities with a turnover of Rs1.5 crore per annum were exempted from payment of excise duty. That threshold has been lowered to Rs20 lakh for most of the states under GST. As these sectors are handicapped of the essential infrastructure required for tax compliance so they have to depend on intermediaries which add to their compliance cost.  Against this backdrop , the release of GST app after a week of its implementation can be called as a faulted start.

The delayed input tax credits have also affected working capital requirements of MSMEs  badly. The government had announced composition scheme for the tax payers (threshold limit 1.5 crore) but there are not much takers of this scheme because it is only for intra state supplies and input tax credits can’t be claimed by a dealer opting for this scheme.

3)      Technical glitches

IT is the backbone of GST. Industry has voiced concerns over the issues faced during matching invoices and other tax filing procedures.

The above limitations merit discussions but also taking into account that the government is constantly making efforts to take measures for improving the GST. Slashing of rates on 200 items in November 10 is a much appreciated move. The average shortfall of revenue has also narrowed. The improved ratings in the Ease of doing business and Moody’s ratings allude to the fact that in the long run India’s economy will benefit from this reform. However, going by Keynes statement that in the long run we are all dead, a good policy requires both short term and long term consideration. The government could have introduced GST in phases, by initially targeting companies and then taxing MSMEs. This would have given breathing time to MSMEs to equip themselves with the necessary infrastructure before this major overhaul. The government is mulling direct tax reforms. The government has already set up a task force to draft a new direct tax legislation. Hope more wisdom will be reflected while implementing Direct Tax Reforms.

What is happening with India's telcos?

Presently the telcos are neck deep in debt. The telecom industry’s debt to banks is estimated at  4 lakh crores. The telcos are demanding for a stimulus in this sector as in their view the present situation is a result of unfavorable government policies and due to a new entrant in this sector. The ministry of telecommunications has said that the solution for aiding this sector would have to be done at the policy level to keep sector alive.

Telcos argue that the sector is too critical to be allowed to fail. In 1998-99 the NDA government bailed out telecom operators. At that time the mad bidding for voice prices was the reason for the crisis in the sector. However, the bailout was followed by a boom. But the question arises what is government bailing out -  A wrong business decision or its wrong decision?

According to telcos the high astronomical prices during the rebidding of spectrum in 2014 was a result of faulty government policies. The revenue share model, present GST rates, and the high spectrum fees are some of the major problems cited by telcos.

However, it should also be noted that the telecom companies in India were not investing in the network. They were investing in infrastructure and thus increasing their capital expenditure leading to more debts. Globally the infrastructure expenditure is incurred by the real estate providers. As the companies were not investing in technology it got a big jolt when the new entrant came with unmatched data services.

The telcos are now considering mergers as a solution to alleviate their present woes. In India, there are many telecom operators. There is no country around the world having so many operators, so possibly the merger can be a good step. But it should also be noted that two bad telecom operator can’t give a good telecom operator. The merger between Reliance and Aircel didn’t work because banks did not agree to the merger. This is because the merged entity would result in a larger write-off which will wipe out Rs. 25000 crore from the banks’ balance sheet.

The solution lies in both government and telcos agreeing to take steps to sustain this sector. The telcos need to divest from the business which ain’t considered productive. The government can act as a facilitator by easing the procedures for mergers. Also, the telcos should start investing in new technologies and upgrading networks constantly.

Banking Regulation (Amendment) Bill

The Rajya Sabha has passed the Banking Regulation (Amendment ), Bill. The Bill seeks to replace the Banking Regulation (Amendment) Ordinance , 2017 and amend Banking Regulation Act, 1949. It amends the provisions related to stressed assets.

The Bill empowers the RBI to direct banks to initiate proceedings under the Insolvency and Bankruptcy Code, 2016. RBI’s internal advisory committee has identified 12 large stressed cases for proceedings.

While the humongous problem of NPAs call for a strong institutional framework, there have been questions related to the recent powers vested to RBI on two grounds –

1)      Whether the RBI required such special powers or such powers were already conferred to it under Banking Regulation Act 1949?

2)      Is it advisable to confer RBI with additional powers?

Section 35A of the 1949 Act allowed the RBI to issue binding directions to banks in ‘public interest’ or where the functioning of a bank is detrimental to its interests, among others. The question is whether a high level of NPAs qualifies as ‘public interest’ or ‘detrimental to the interests of the banking company' and therefore allows the RBI to use the powers under Section 35 A to direct banks to initiate recovery of proceedings under Insolvency and Bankruptcy Code.

The opponents of the Bill expressed concerns that focussing on such microeconomic issues might interfere with RBI’s role of framing policies on macroeconomic issues. RBI, as a regulatory institution, is expected to frame broad guidelines, ensure the stability of the banking system and prevent risks to the financial system. As the resolution of stressed assets is a commercial decision so it should be left to the banks. The RBI data shows that about 88 % of the NPAs are in the Public Sector. As the government is the majority shareholder in these banks so it had the authority of initiating proceedings.

The proponents argue that resolving of NPAs is an important task as it has serious repercussions on the economy. It is also argued that RBI’s mandate to initiate proceedings will allay fears of future investigations. The Economic Survey 2016 – 17 mentions that inherent threat of punishments is one of the major reasons due to which bankers delay the decisions of writing off the loans. The new powers will also boost the investor’s confidence.

Though the menace of NPA is because of many factors (giving infrastructure loans, court proceedings on 2G scam and coal allocations, land acquisition etc), it cannot be denied that misgovernance was the major factor. The present bill has enlarged the functions of RBI and it is hoped that more steps are taken in the direction of freeing public sector banks from political interference.

Source : PRS Legislative Research

Transparency in Judicial appointments

The Supreme Court has recently taken a historic decision to disclose the reasons in favour of recommendations by the collegium system with regard to judges. The recent transfer of Justice Jayant M Patel might have triggered this recent move.

 After the Second Judges Case (1993) the Supreme Court reserved the autonomy in the selection of judges as the judgement held that “consultation” of the President with the Chief Justice of India in matters of appointment meant “concurrence”. Though in the Third Judge case (1987) SC opined that consultation meant consultation of the plurality of judges, the appointments had always remained debatable due to the secrecy maintained by the collegium. It was also a bone of contention between the judiciary and legislature.

The collegium note uploaded online gives a brief summary of the professional performances of the candidates, including a rating on their judgements. Suhrith Parthasarthy , an advocate in Madras High Court , in his article “Collegium and Transparency”, which appeared in The Hindu dated 1 November 2017, observed how the present system still falls short of achieving the goal of transparency.

Though a certain degree of discreetness is required as in many cases the reasons might pertain to sitting judges, it is important to strike the right balance between disclosure and discreetness.

Nevertheless, this step albeit small is a step in the right direction and it is hoped that Supreme Court will introduce all other reforms gradually, disclosure under RTI being the foremost.

Return of Fiscal Activism

Japan’s fiscal stimulus, increasing of fiscal deficit targets in Eurozone economies, UK chancellor Hammond’s mulling reviewing his predecessor’s plan on budget, apparently indicate that fiscal activism is gaining currency in developed economies these days. The developed economies are mired with low or zero interest rates (negative interest rates in Japan) and monetary policy has reached its limit. These low interest rates had set up perfect ground for the fiscal policy to emerge as a powerful tool for these economies. In the liquidity trap scenario the fiscal multipliers are large and hence it is conducive to resort to fiscal activism (Strike when the iron is hot)

The genesis of fiscal activism can be traced back into Keynesian economics. The idea of welfare state was embraced during great depression of 1930s .

But Greece’s sorry tale of fiscal expansion following its adoption of the euro in 2001 is the epitome of fiscal activism gone wrong. The adverse consequences in fiscal activism have led to crises in Latin American countries, mainly in Venezuela.

A country’s fiscal space is judged not only by interest rates but also whether country’s public finances are on sustainable path . The basic equation of debt sustainability which includes factors such as country’s primary deficit , nominal GDP growth rate , nominal effective rate of interest and Debt/GDP ratio should be given prime importance. One of the criticisms against fiscal activism lies in  government’s inefficiency in understanding consumption patterns of the society. The ghost towns in China is a reminder of government’s failure to understand the demands of the people in the economy. Thus ill framed fiscal stimulus worsens the problem by increasing the number of non performing assets .

The fiscal activism should be used as a countercyclical policy i.e. an expansionary fiscal policy should be undertaken during economic slowdown and contractionary fiscal policy should be undertaken during boom. If the nature of polity acts as a straitjacket in resorting to contractionary fiscal policy then fiscal activism should be avoided because it will lead to huge fiscal deficits. The economic survey 2016-2017 highlights that the two episodes of Indian macroeconomic vulnerability in 1991 and 2013 were caused due to application of both procyclical and countercyclical policy. 

During 1980s the government increased fiscal deficits as a response to accelerating growth . The 1991 Balance of payment crisis again forced government to resort to expansionary fiscal policy. Similarly, during the 2000 growth boom government increased its spending program. But again in 2008, government had to increase its fiscal deficits due to Global Financial Crises. The combination of procyclical and countercyclical policy worsened the inflation in 2013.

The experiences of fiscal activism underscore that one-size fits all approach shouldn’t be followed. The authorities should take into account a plethora of factors and not just the interest rates while considering fiscal activism as a tool to solve economic problems.

- Tanushree Dutta

Inflation Targetting – Is India on the right track ?

Recently RBI rules have been amended and RBI has adopted inflation targeting as its monetary policy strategy. As per government notification an inflation target of 4% will be followed till March 2021. This article while revisiting the genesis of inflation targeting (IT) attempts to find out the benefits of IT for India and the challenges that India face in making IT successful.

Genesis of Inflation Targetting

Milton Friedman once said that inflation is anywhere and everywhere a monetary phenomenon (Fishers’s equation of exchange) and hence it is controllable by central bank . Pre 1970s was a period of fixed exchange rate and hence because of the principle of macroeconomic trilemma there were constraints on Central Bank in maintaining inflation . The early 1970s saw the breakdown of fixed exchange rate and a move towards managed exchange rates. Flexible exchange rates gave the monetary authorities the independence to using monetary tools for solving adverse economic shocks. In the mid 1970s many industrial countries resorted to money growth targets. Under this approach central banks sought to control inflation by aiming for intermediate target rates of monetary growth. However, this approach failed in achieving inflation targets as the relationship between M1 growth and inflation is not tight (mainly because of shifts in money demand).

It was realized that given inflation the prime target the policy should aim at targeting inflation, rather than money growth. Thus from 1990s there was a shift towards inflation targeting. Some economists believe that inflation targeting is an effective tool as it helped followers of inflation target to achieve low levels of inflation. But critics argue that low inflation was the result of global non-inflationary situation.

Benefits of inflation targeting for India

Prior to inflation targeting RBI used to target a host of indicators and this created uncertainty in markets. For example, in 2004 -07in order to prevent rupee from appreciation due to surge in foreign exchange inflow RBI lowered the interest rates . This led to credit boom and fuelled inflation as it was a pro cyclical measure.  Thus inflation targeting will act as a bulwark against discretionary monetary policy. The requirement of the monetary policy committee to publish reports after their meeting will further help in ironing out the wrinkles of uncertainities.

Challenges ahead

1)      Supply side inflation: The economic survey 2016-17 mentions that while headline inflation (as measured by CPI) has lowered but core inflation has increased. This reflects the persistence of supply side inflation in India. It is worth mentioning that inflation targeting can target demand side inflation and not supply side inflation. In view of this appropriate measures should be taken to solve supply side bottlenecks.

2)      Weak transmission mechanism: For inflation targeting to be successful the country needs to strengthen its transmission mechanism. For instance, lowering the interest rate at the time of low inflation may not have desired impact on the inflation in the event of existence of weak transmission mechanism .

3)      Paucity of data: India’s economy is mired in poor data.  For IT to be successful the quality of data needs to be improved. Also there should be willingness to revise the base year of CPI so as to ensure that it is a good representative of consumption expenditure.

Thus taking various aspects into consideration the recent announcement of RBI to move towards MCLR in a broader spectrum is a step in right direction because it will help in improving transmission mechanism. There is also wisdom in RBI’s mandate of targeting a band of inflation rather than a fixed rate as it will provide elbow room for reacting to short term economic problems without creating volatility in the market.

- Tanushree Dutta

Agricultural Distress

India is a country mired with agricultural distress. The government had promised to double farmer’s income by 2022  but the recent protests by farmers for loan waivers paint a different picture.

Indian agriculture is characterized by low scale and low productivity. About 85% of the operational landholdings in the country are below 5 acres and 67% farm households have holdings below 1 acre. The agriculture in India is exposed to vagaries of nature. Many households don’t have access to irrigation. The problem is exacerbated by market risks and institutional failures.

The latest National Sample Survey on Situation Assessment Survey of Agricultural Households (NSS-SAS) gives dismal figures. 13.9% farm households experienced negative returns from crop production during 2012-13. Non farm income comprised 40 % of the income of the households but the access is to non farm incomes is highly skewed.

The question now arises is that given this backdrop should government go for loan waivers to the farmers.

Firstly the waivers would mean waivers only for the loans that have been taken from banks. But mostly the poor farmers rely on non institutional sources for the loans which involve a higher rate of interest. This means that many of the potential beneficiaries would get excluded. The farmers borrowing from non institutional sources are equally vulnerable.

Secondly, the waivers might arise the classic case of moral hazard problem. It should be noted that farmers often take consumption loans and this pushes them towards a vicious cycle of debt. A loan waiver would encourage them in taking consumption loans. It severely erodes the credit culture, with dire consequences to the banking business. There is a strong need to change such kind of farmer’s mind set.

Thirdly, in many cases, one household has multiple loans either from different sources or in the name of different family members that entitles them to multiple loan waivers.

Loan waiver is not even a good short term palliative. The expenditure on loan waivers has serious drawback on developmental expenditure. For instance, loan waiver may cost UP government 36000 crore, which is 4.4 times the State’s capital expenditure in Agriculture including irrigation and flood management. The worst part is that due to inclusion and exclusion error such an enormous expenditure is likely to exclude most of the farm households in dire need of relief and include some who do not deserve such relief on economic backgrounds. The CAG findings in the Agricultural Debt Waiver and Debt Relief Scheme also highlighted this problem.

For providing immediate relief to the needy farmers, a more inclusive approach is to identify the vulnerable farmers’ based on certain criteria and give an equal amount as a financial relief to vulnerable and distressed families. The government can also utilize its machinery established for Direct Benefit Transfers for identification of vulnerable households.

The sustainable solution to indebtedness and agrarian distress lies in treating farmers as entrepreneurs. They must be incentivised to take calculated risks. This entails improving farmer’s knowledge about the market. The recent initiative of the government of e-NAM is a much-appreciated move.

As agriculture is a state subject so centre must promote states to engage in competitive federalism. A  state can reward its farmers for paying its loan on time , by increasing the development expenditure towards agriculture in the budget. This will not only improve the infrastructure in that state but will also create demonstration effect for the farmers in other states. Centre can come with policies such as giving more guarantees to loans to such states. This will provide an added impetus to the state government .

Agro processing industries and the non farm sector should be encouraged and farmers should be made aware of how non farm sectors help in diversifying the risks. The success of agro processing industries lies in consolidation of farms. This requires computerized land records. Economists have long argued for taxation of farmer’s income above a certain threshold as an effective measure to reduce inequality in rural areas and increased revenue for rural infrastructure. This solution albeit  a right one , often invites political complexities .The success of all these schemes requires awareness of the farmers mainly the middle and small scale farmers. Farmer’s Friends initiative in ATMA is a step in the right direction.

India’s geography has blessed her with vast and fertile Indo-Gangetic plains. Doubling farmer’s incomes is not a piped dream. We cannot alter the circumstances overnight. But to achieve great reforms, one must continue to move towards the goal with sincerity.  In order to translate “Jai Jawan , Jai Kisan” into reality there is a strong need to uplift farmers’ position atleast near to that of jawans.

(This article has borrowed some facts and ideas from "Think beyond loan waivers", which appeared in The Hindu dated 20 July 2017)