The Leap Blog: August 2021

Wednesday, August 25, 2021

What year in the history of an advanced economy is like India today?

by Ananya Goyal, Renuka Sane and Ajay Shah.

India has been stepping out from poverty into middle income. It is estimated that the proportion of persons below the PPP$1.90 poverty line has dropped to 87 million in 2020. In thinking about India's journey, it is interesting to ask: In the historical journey of advanced economies, What year in the history of the US or UK roughly corresponds to India of 2021? This is a good way to obtain intuition on where India is, in the development journey.

GDP measurement is a daunting enterprise. GDP measurement is particularly weak when it concerns the deep past of the UK or the US, or the Indian present. Measuring asset ownership such as cars and other assets can induce valuable insights. For many products (e.g. cars, washing machines, mobile phones, denim) we should look at the extent to which the product has reached into the households of the country. In this article, we ask: What is a time point in the history of the US or the UK which is comparable with where India is today, in terms of household asset ownership?

This is connected with the question "How big is the Indian middle class?" when we apply certain thumb rules such as "to own a car is to be middle class".

While these are fascinating questions, such comparisons have to be undertaken with care. When the highways are weak or when the public transport is strong, households will find cars less attractive. Closer to the equator, cooling technologies will be more appealing. And, most important, technological progress across the years has resulted in a sharp decline in the prices of many of these assets, through the wonders of mass production of assets like cars, and through Moore's law for CPUs.

In the interpretation of asset ownership information, we should maintain a distinction between causes and consequences. The causes are the factors such as household prosperity or climate or cost reduction, which shape the decision of household purchase. The consequences are about how a given household asset reshapes the welfare and culture of the household. The consequences appear more similar across space and time. As an example, the impact of personal transportation upon an individual is similar across countries and decades, regardless of the the decline in the real price of an automobile and the expansion of household income.

GDP measurement is faulty, and asset ownership measures across space and time are clouded by differences in the climate and by technological progress. No one element of this article is the single truth. We should assemble an overall picture in our minds, pooling all these aspects of the truth.

Per capita GDP

In 2020, per capita GDP in India (in PPP terms at 2011 prices), is $6806. Looking back into the history of the US and the UK, we get the dates:

	Comparable year in US history	Comparable year in UK history
Per capita GDP	1896	1894

This places India of today as being roughly like these advanced economies at the dawn of the 20th century. By this measure, India is about 120 years behind the US or the UK in terms of economic development.

Women's labour force participation

Looking back into US history, the first measurement of women's LFP seems to be in 1890 and it shows a value of 18.2% (Smith & Ward, 1985). The women's LFP in India for 2020-21 is measured by CMIE at 9.2%. By this measure, India is at a state of maturity which is older than 1890 for the US.

Asset ownership

We use data from the September - December, 2019 Consumer Pyramids Household Survey to measure asset ownership in India. For each asset, we compute the fraction of households which own a stated asset.

Asset	Share in India today (%)	Comparable year in US history
Car	6	1915
Refrigerator	59	1945
Air conditioner	7	1955
Washing machine	25	1955
TV	95	2000
Computer	8	1985

Cars: In India today, 6% of households have a car. This value was obtained in the US in 1915.
The Ford Model T was introduced in 1908. Thus, the productivity gains associated with modern manufacturing have been in play for over a century before we get to the India of today. It was harder for a US household in 1915 to buy a car, as cars were then more expensive. Our measure (1915) is an over-estimate on account of improvements in mass production.
There are about 300 million households in India, so the installed base of cars used by households is about 18 million.
Cooling equipment: Demand for refrigerators and air conditioners in the US is likely to be lower than what we see in India owing to the climate. And, there have been great advances by way of cost reduction of refrigerators.
At present, 59% of Indian households have fridges, and the US was at such a value in 1945. Similarly, 7% of households in India have air conditioners, a value that was seen in the US in 1955. Both these values (1945 and 1955) are an over-estimate owing to (a) Differences in the climate and (b) Improvements in mass production.
With about 300 million households, these values map to about 20 million air conditioners and about 180 million refrigerators, in homes. The total Indian market size for these products is, of course, greater as there are also purchases by organisations like restaurants.
Washing machines: Washing machines are interesting in that there is no difficulty with the difference in climate, but there are cost reductions owing to improvements in mass production.
The US was at the present Indian value of 25% in 1955. This estimate (1955) is likely to be an over-estimate on account of improvements in mass production. An anonymous commentator points out that if clothes can be washed using cheap labour, the incentive to buy a washing machine is lower.
About a quarter of 300m households is about 75 million washing machines in existence in households in India today.
Electronics: The Indian value for television sets of 95% looks near-complete. This was only achieved in 2000 in the US.
With home computers, the Indian value of 8% is comparable to that seen in the US in 1985.
Both these values (2000 and 1985) are over-estimates owing to the dramatic decline of prices of electronic equipment.

Monday, August 23, 2021

Author: Harleen Kaur

Harleen Kaur is a regulatory affairs and public policy researcher and lawyer practising in a Delhi-based law firm.

On this blog:

How elements of the Indian state purchase drugs, 19 August 2021.
Response to the Consultation Whitepaper on 'Strategy for National Open Digital Ecosystems (NODEs)', 12 July 2020.
Legal and regulatory framework for laboratory testing in India: A case study for Covid-19, 3 July 2020.
Information about COVID-19 in India, 13 June 2020.
Incentive compatibility and state-level regulation in Indian drug quality, 1 June 2021.
The rise of government-funded health insurance in India, 21 January 2019.

Thursday, August 19, 2021

How elements of the Indian state purchase drugs

by Harleen Kaur, Ajay Shah, Siddhartha Srivastava.

There is one well known problem in India: the problem of drug quality. A significant fraction of the drugs purchased and consumed are sub-standard.

There is another well known problem in India: the difficulties of government contracting. When state organisations choose to buy instead of make, they face difficulties in the entire pipeline from bid preparation to tendering to contract disputes to contract renegotiation to payments. Weaknesses in government contracting are a cross-cutting problem that hamper the emergence of state capacity in all fields.

Research on government drug purchase thus lies at the intersection of two literatures: the drug quality literature in the field of health and the government contracting literature in the field of public administration.

Government purchase of drugs is particularly important for three reasons:

The government is a large buyer of drugs, and the people would become more healthy if the quality of government-purchased drugs could go up.
If procedures for drug purchase by the government are improved, this could potentially have an impact on the optimisation of an important subset of firms who may then improve their quality standards, and this would impose positive externalities upon private buyers of drugs.
There are some policy pathways based on information about government testing of drugs, where the release of test data into the public domain, as a side effect of a well structured government purchase procedure, can also reshape the incentives of private firms in favour of higher quality.

A research literature on government drug purchase is required. For all researchers looking at this field, obtaining basic institutional knowledge is a bottleneck. A first building block of this is a description of how various elements of the Indian state buys drugs. This is the kind of paper that everyone wants to read but nobody wants to write. We have made a first attempt at this descriptive paper.

Tuesday, August 17, 2021

Author: Devendra Damle

Devendra Damle is a researcher at the National Institute of Public Finance and Policy.

On this blog:

Bringing gender-equality in the Hindu Succession Act: An overdue reform, 14 December 2021.
Litigation in public contracts: some estimates from court data, 26 May 2021.
Estimating the impact of the draft drone regulations, 19 March 2018.
Replace voice votes, 11 April 2017.
Does the NCLT Have Enough Judges?, 6 April 2017.
How well is India's land record digitisation programme doing: Findings from Rajasthan, 14 December 2017.

Monday, August 09, 2021

Sudden Rise of the Floaters

by Rajeswari Sengupta and Harsh Vardhan.

The first two months of 2021-22 have witnessed a remarkable new trend in the corporate bond market—a sudden rise in the issuance of floating rate bonds or “floaters” and the use of the 91-day treasury bill yield as the reference rate in these bonds, instead of the yields on dated government securities (G-Secs).

We conjecture that one possible reason behind this new development could be an increase in the perception of interest risk on the part of the bond market participants. This in turn may have been a result of the active yield curve management undertaken by the Reserve Bank of India (RBI). If indeed dated government bonds such as the 10-year G-Secs have lost relevance as benchmark securities then this can lead to serious mispricing of risk in the economy, an unintended consequence of the RBI’s bond market intervention.

An interesting development in the bond market

Over the three-month period from April to June 2021, about 7 percent of the total corporate bond issuance of Rs 1.02 trillion consisted of floating rate bonds. While this percentage looks small, it is important to keep in mind that for the previous ten years or more, the share of floating rate bonds in the total issuance of corporate bonds has been less than 1 percent.

It is also important to note that the firms issuing these bonds and the investors investing in them are not a new class of issuers and investors. They are the same issuers and investors who were issuing and buying fixed-rate bonds until recently. In particular, 100 percent of the floating rate bond issuers now are non-banking finance companies (NBFCs) who were earlier issuing fixed rate bonds, and the investors are the same mutual funds and banks who were investing in fixed rate bonds earlier. This could imply that their behaviour has now changed due to external developments. It is as if the bond issuers and investors have suddenly developed a taste for floaters.

Corporate bonds are typically issued with a maturity of more than one year, along with a coupon, which is the rate of interest to be paid on the bond. Most bonds have a ‘fixed’ coupon—the rate of interest on the bond is decided at the time of issuance of the bond and remains fixed over the life of the bond.

This rate is a function of two factors – (i) the prevailing risk-free interest rate for the maturity matching that of the bond, and (ii) the credit risk spread that is added to compensate the investors for the default risk associated with the issuer.

The risk-free reference rate is ideally the interest rate on the government security of similar maturity. The credit spread is the function of the credit rating of the issuer. For example, if a AAA-rated issuer wants to issue a 5-year maturity corporate bond, then the risk-free reference rate will be the rate for a 5-year government security (let’s say 5.7 percent). If the credit spread of the AAA-rated issuer is an additional 100 basis points (1 percent), then the bond will be issued with a fixed coupon of roughly 6.7 percent. Note that this rate will apply to all the future interest payments by the issuer until the bond matures even if the underlying risk-free rate changes. This means that the investor in this bond is taking the interest rate risk. The secondary market price of these bonds reacts to changes in the underlying interest rates – the bond prices fall if the risk-free interest rate increases and bond prices go up if the risk-free rate decreases.

In the case of a floating rate bond, the main components of determining the coupon remain the same—a reference rate and a credit risk premium. The crucial difference is that the reference rate is no longer fixed but changes over time. Hence, these bonds are referred to as ‘floating’. The coupon on these bonds clearly specifies the reference-floating rate.

If the bond in the example cited above were a floating rate bond, then the coupon on it will not be a fixed rate of 6.7 percent. Instead, it will be the rate on 5-year government security at the time of interest payment plus 1 percent. In other words, for a floating bond, the applicable interest is computed at the time of payment of interest. If the 5-year government security rate moves up by 0.5 percent in a year then the interest rate payable will become 7.2 percent. The investor in such a bond is more protected from interest rate risk and the prices of these bonds in the secondary market fluctuate much less with movements in interest rates.

In the last two months, floating rate bonds worth Rs 70 billion have been issued in the corporate bond market, almost entirely by private companies. Overall, bonds worth Rs 793 billion have been issued by the private sector including NBFCs. The floating rate bond issues in these two months thus represent around 10 percent of private sector bond issuance.

An interesting feature of these floaters issued in the last two months is that all of them have used the yield on 91-day treasury bills (T Bills) as the reference rate. Notwithstanding the fact that these corporate bonds have maturities ranging from 2 to 4 years, yields on dated government securities (i.e., G-Secs with maturity of more than 1 year) have not been used as a reference.

What might explain this sudden preference on the part of the issuers and investors for these floating bonds?

What might be going on?

One possibility could be a heightened perception of interest rate risk. Bond investors might be harbouring the belief that the interest rates on dated G-Secs are unlikely to remain at their current levels. As discussed earlier, issuing floating rate bonds is one way to mitigate interest rate risk. This raises the next question – why would the perception of interest rate risk suddenly go up now?

We conjecture that this could be a result of the manner in which the RBI has been managing interest rates in the government bond market. The Covid-19 pandemic presented the Indian economy with an unprecedented challenge. A combination of falling tax revenues and rising expenditure on account of fiscal stimulus resulted in a massive increase in the fiscal deficit of the government, and a corresponding rise in government borrowing from the bond market. In 2020-21 the consolidated government borrowing was a whopping Rs 21.5 trillion and the planned borrowing for 2021-22 is roughly Rs 19.6 trillion. The overall government debt to GDP ratio is roughly 90 percent, the highest ever.

The RBI on its part has taken multiple steps to ensure that interest rates are kept low in the bond market so that the government’s cost of borrowing remains under control. It has allowed several primary auctions of G-Secs to devolve on primary dealers and has even canceled auctions when it did not receive bids at rates that were low enough. In addition to its standard open market operations (OMOs), it initiated the Operation Twist program whose objective was to bring down interest rates at the long end of the yield curve and push up rates at the short end. This meant that the RBI was buying long-dated G-Secs and selling shorter maturity bonds.

In March 2021 the RBI launched a program called the G-SAP wherein for the first time it pre-committed to buying a specific amount of G-Secs. These bond market interventions are mostly aimed at capping the interest rate on the benchmark 10-year G-Sec at 6 percent. As a consequence of these actions, the RBI has ended up owning a substantial amount of the 10 year benchmark government bonds (link).

It is possible that bond investors believe that the RBI will not be able to suppress the interest rates for too long, and the rates will rise sharply and suddenly. This could be either because of the large volume of G-Secs the government needs to issue to finance its deficit or because of growing inflationary concerns in the Indian economy (CPI inflation has exceeded the upper limit of 6 percent of the RBI’s targeted inflation band in both May and June 2021), or because of external factors such as rising inflation in the US.

This is akin to a spring that has been forcefully compressed but can bounce back anytime. If the rates suddenly go up, holding fixed coupon bonds will lead to losses, as explained earlier. This increased risk perception might be one possible explanation as to why the investors now prefer floating rate bonds.

Arguably, another unintended consequence of the steps taken by the RBI to lower the long-term G-Sec yields and suppress the organic evolution of the yield curve in response to market forces may have been that the bond market participants have lost confidence in the yield curve.

In the past whenever inflation went up, 10-year G-Sec yields would also go up, implying a positive correlation between the two variables. The underlying idea is that rising inflation is usually followed by a tightening of the monetary policy stance which in turn leads to higher long term bond yields.

For instance, figure 1 below plots the 10-year G-Sec yield alongside CPI (consumer price index) inflation from 2004-05 to 2013-14. This was a period of high and rising inflation. CPI inflation went up from 3.8 percent in 2004-05 to more than 10 percent in 2012-13. Concomitantly, the 10- year rate went up from 6.6 percent in 2004-05 to more than 8 percent by 2012-13.

Figure 1: CPI Inflation and 10year G-Sec yield, 2004-05 to 2013-14

But recently this correlation seems to have broken down. We can see this clearly in figure 2, which plots the two series using monthly data, focusing on the period from March 2020 to June 2021. CPI inflation began rising from May 2020 onward. It consistently breached the 6 percent upper limit of the RBI’s targeted inflation band during the period April-October 2020, increasing from 5.8 percent in March to 7.6 percent in October. More recently it went up from 4.2 percent in April 2021 to 6.3 percent in June 2021.

Figure 2: CPI Inflation and 10year G-Sec yield, March 2020 to June 2021

However, this time around, rather than increasing, the 10-year G-Sec yield actually fell from 7.5 percent in April 2020 to 5.8 percent in May, since then holding more or less steady around 6 percent. These developments suggest that G-Sec rate might be distorted by the RBI’s interventions, which in turn might explain why some investors are turning to the T Bill rate as a preferred reference rate.

Other explanations are, of course, possible. The rise of floaters could also be a result of companies expecting interest rates to come down, in which case they would not want to issue long-term debt at higher rates. This however seems unlikely. Given that inflation continues to be a concern, interest rates are more likely to go up rather than down, and sooner or later RBI would need to start normalising the surplus liquidity situation that the financial system is currently in.

Alternatively, floaters could be issued if the private sector is tapping a new class of investors, who are interested in buying bonds but do not want to run any interest rate risk. But the issuers of and the investors in the floaters are exactly the same entities that were participating in fixed-rate bond transactions earlier.

Finally, it is also possible that the funding requirements of the NBFCs (the sole issuers of floating rate bonds right now) have undergone some changes which might have increased their preference for these bonds.

Conclusion

We are observing an interesting new development in the corporate bond market. The rise of floating rate bond issuances by private NBFCs, and the use of the 91day T Bill rate as the reference rate seem to indicate a change in the preferences on the part of both issuers and investors.

We conjecture that one reason that might explain this development is the intervention in the bond market by the RBI to control G-Sec yields. Specifically, it is possible that the RBI’s persistent interventions have caused some market participants to lose trust in the yield curve. This possibility needs to be explored further in the future.

If there has indeed been an erosion of credibility in the yield curve, then this would be a serious problem. The yield curve is a fundamental construct in a market economy, as it defines the interest rate structure that is used to price debt. As a result, if the yield curve is distorted, then interest rate risk is being mispriced. The associated misallocation of resources could prove to be costly, damaging the economy just as it struggles to recover from the Covid crisis.

Harsh Vardhan is Executive in Residence at the Center for Financial Studies (CFS) at the SP Jain Institute of Management and Research. Rajeswari Sengupta is an Assistant Professor of Economics at the Indira Gandhi Institute of Development Research (IGIDR). The authors thank Josh Felman and an anonymous referee for their useful suggestions.