Who lends to the Indian state?

by Aneesha Chitgupi, Ajay Shah, Manish Kumar Singh, Susan Thomas and Harsh Vardhan.

Public finance researchers in India have paid great attention to debt and deficits. By now, the main messages of the field have started sinking into common knowledge: that it is good to run primary deficits in most years, so as to create space to surge the deficit once in a while when faced with a crisis. There is an adjacent field of public debt management that is equally important. Here, the strategic question is: How should the government borrow? From whom? Debt management strategy has not received the required level of interest.

Strategic thinking in debt management

A sound public debt management strategy must cater to three objectives:

• The mechanism for borrowing must not induce economic distortions upon the domestic economy.
• It must create strategic depth of being able to borrow on a very large scale when faced with great challenges, once every few decades.
• It must induce sustainable mechanisms for reasonably low cost borrowing, at reasonably predictable rates, for the long term.

There are four main pathways to choose from in debt issuance:

1. Monetisation of the deficit. Here, the central bank distorts the monetary base with `fiscal dominance’ where it buys the bonds issued by the government.
2. Coerced borrowing from financial firms. These are typically regulated firms, who are coerced using the tools of financial regulation.
3. Borrowing from voluntary participants (domestic or foreign). This is done through local currency bonds issued domestically, possibly nominal and possibly inflation indexed.
4. Borrowing abroad using foreign currency denominated bonds. As an example, this could involve Yen denominated bonds issued in London.

As with many other countries, we started out in India with the first method (monetisation of the deficit). This induces an economic distortion: the loss of monetary policy autonomy. A long journey of monetary policy reform took place, from the Ways and means agreement of 1993, to the Monetary policy framework agreement in 2015 that ushered in inflation targeting. This freed up monetary policy from the limitations imposed by debt management. In 2015, there was an attempt at institutional reform, in the form of the establishment of the Public Debt Management Agency (freeing up the Reserve Bank of India of the responsibility of issuing public debt), but this did not come to pass.

From 1993 onward, the main strategy for public debt management in India has involved method 2 in the list: a system of `financial repression’ where the government borrows from coerced financial firms. This is a tax upon financial intermediation. The interest rates discovered through government borrowing are important prices that impinge upon the economy. But these rates are distorted owing to the presence of coerced buyers of government debt. The lack of voluntary lenders creates the lack of strategic depth. The government is limited in how it can expand its borrowing when faced with special situations.

From the late 1990s onwards, economists and thinkers have sought to enhance fiscal prudence in India through the mechanism of fiscal responsibility law. It is increasingly clear that this does not work. In recent work, Datta et. al. 2023 show that the Indian constitutional arrangements frustrate the possibility of Parliamentary law imposing fiscal discipline upon the union government. Once this idea is internalised, there is one main path towards fiscal responsibility: market discipline. This requires removing the system of financial repression.

Who lends to the Indian state?

In this context, the question Who lends to the Indian state? attains importance. A recent paper by Aneesha Chitgupi, Ajay Shah, Manish Singh, Susan Thomas and Harsh Vardhan examines this question. For a period of 10 years, we assemble information from multiple sources, which were all available in the public domain, to examine the nature of lenders to the Indian state. Some discoveries that we make are:

• The SLR went down in the last decade. This meant that the extent of bank funds mandated for the government decreased. However, the actual investments by banks in government debt securities was higher than what was mandated.
• Simultaneously, there was major growth in the role of insurance and pension funds lending to the government. While de jure financial repression of banks declined, there has been no such retreat with pensions and insurance.
• All the three groups of financial firms bought a lot more government bonds as compared with the de jure requirements. Excess ownership went from about 0 in 2011 to Rs.30 trillion in 2021.
• How did the government increase borrowing over the last decade, while simultaneously elongating the maturity profile? The answer lies in (a) Strong growth in insurance and pensions industries, and (b) Excess ownership of government bonds by coerced industries.
• The voluntary lenders are the private firms, MFs and FIIs, who are 4.8% of investors in the government debt market for 2021. India (along with China) remains an outlier in having very low borrowing from international debt markets.

Important questions for the future

This field is target rich with interesting questions, some of which are:

1. Why do financial firms lend so much to the government?
2. What will the structure of lenders to the government look like, 10 years out into the future?
3. If a big surge in borrowing is required, where will it come from?
4. How are households and firms changing their behaviour in response to the financial repression tax?
5. What is the path to fiscal responsibility?

Conclusion

The field of public finance in India has studied deficits and debt. There has been work on the institutional arrangements for debt management (i.e. the establishment of the Public Debt Management Agency). There has been relatively little work on the economic reasoning, the strategic thinking for debt management. In this paper, we offer novel insights and facts for this journey. More research is required, at the interfaces between public finance, finance and public administration, to grow knowledge on the important field of debt management strategy.

How to achieve fiscal responsibility in India

by Ajay Shah.

The FRBM Act has not delivered in reining in Leviathan. India continues to suffer from chronic fiscal problems. Recently, Montek Ahluwalia and Rathin Roy have written about the new thinking that must go into fiscal responsibility legislation.

Laws that protect against fiscal irresponsibility

It's hard to restrain Leviathan by using a fiscal responsibility legislation. In recent years, we have a procession of Finance Bills that disregarded the FRBM Act. The FRBM Act is a mere Act of Parliament, and can be amended each time a Finance Act is enacted.

There are a few success stories of very strong legal protections against fiscal irresponsibility, such as the `Debt Brake' constitutional amendment that was done in Germany and a few other places. Short of this, it's hard for Parliamentary legislation to make a significant difference. We in India are unlikely to summon the political capacity to do this.

The role of the bond market

It's also interesting to see that most countries have achieved superior fiscal responsibility than India, without a Debt Brake style constitutional amendment.  The key thing to focus on is financial repression. When the government faces a captive bond market, it feels it can get away with fiscal irresponsibility.

What has really mattered to advanced countries achieving fiscal discipline is not fiscal responsibility legislation but the pressure of the bond market. E.g. look back at how in recent years, the bond market stopped European governments in their tracks. The famous quotation by James Carville, sourced from the Wall Street Journal, 25 February 1993, says: I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.

In the present Indian arrangement, we don't do public debt management in a serious sense of the term; we just force financial firms to buy government bonds. This is a tax on formal finance, which has far reaching adverse implications for the financial system and for the economy. It yields easy sale of bonds till the numbers associated with financial repression are exhausted, and an exceedingly difficult time beyond.

Exacerbating the marginal social cost of funds

It is useful to link up financial repression with the concept of Marginal Cost of Public Funds. In OECD countries, this is generally thought to be 1.7: the cost to society of Rs.1 of government expenditure is ~ 1.7. In India, this needs to be adjusted upwards twice: first, for a badly designed and badly administered tax system, and second for financial repression. This demands a very high bar on what is a useful government expenditure: the gains to society for Rs.1 of government spending may have to be as large as Rs.3 for the expenditure to make sense.

The way forward

Hence, the first step in our fiscal journey is the establishment of the Public Debt Management Agency (PDMA), and getting bond market regulation out of RBI. We need to replace the forcible conscription of savings from institutional investors by sound debt management which knows how to sell bonds to voluntary buyers, into a liquid and well regulated market where the bond market regulation is arms length from either debt management or monetary policy or banking regulation.

Micro-prudential regulation should be technically sound. This involves ensuring that banks do not go bankrupt, as they have in India. It should not support and enable financial repression, as has been done. The European crisis has taught us the extreme dangers that come from hitching bank fragility to sovereign fragility. If we wanted banks to not take risk, and we were willing to use intrusive rules about portfolio composition, technically sound micro-prudential regulation should ask of them to hold short maturity bonds issued by high rated countries. Similar considerations apply with micro-prudential regulation of insurance and pensions.

The full picture of macro and finance policy

Israel is an inspiring story of a country that built modern macro and finance institutions, and was bountifully rewarded by the bond market. But it's useful for us to remember that even at the starting point of their reforms, they were never as bad as us; in other words, the gains to us of doing the orthodox macro and finance reforms are even greater than what was seen in Israel.

There are strong linkages between bond market development, price stability and debt management. Hence, we must see the overall strategy for fiscal, financial and monetary reform in a unified way. As an example, see the inter-relations between the three components which were begun in February 2015, of which two were shot down. The debates of March and April 2015 displayed a low appreciation of these inter-relationships, which led to the rollback of two out of the three components. We have begun with one piece, inflation targeting, but haven't done the rest of it. This is the heart of the question of fiscal prudence.

Technology and institutional machinery that will save Rs.75,000 crore a year

by Viral Shah.

In a recent article, Ajay Shah discussed the potential for Aadhaar to help save Rs.75,000 crore per year, by overhauling the administration of susbidies. The first level gains come from using Aadhaar numbers in the databases of every scheme to elimnate ghosts, fakes and duplicates. The second level gains come from enforcing a one price policy. There is an incentive for arbitrage when and only when a commodity has two different prices in the market. Aadhaar technology helps ensure that all subsidised goods are sold at market prices, and the subsidy is transferred directly to the targeted beneficiary. Finally, there is a need to rationalise the subsidy and social safety net policies - who gets subsidies, how do they get them, how are subsidised goods produced, and how they get distributed.

Let's go closer into these questions, envisioning the concrete actions required on some of these fronts.

LPG subsidy

An implementation plan for the LPG was in the Report of the Task Force for Direct Transfer of Subsidy for LPG, Fertilisers and Kerosene where Nandan Nilekani was the Chairman.

The first step of implementing this plan was the cap on the number of cylinders of LPG that can be purchased by a household. Starting with 6 initially, political considerations led to this limit to be raised to 9 and then 12 subsidised cylinders annually. However, as the report notes, the average consumption of cylinders is less than 9 cylinders annually, and this decision should be reverted to 9 cylinders. While this cap has immediately led to a gain, over time, fake LPG consumer connections will be created as there is ample incentive to do so.

To address this requires implementing the second recommendation: to link every LPG connection with an Aadhaar number and deliver cylinders at market prices. The subsidy amount for the first 12 cylinders is transferred directly to the consumer into their Aadhaar-linked bank account as soon as the cylinder is delivered. While this sounds like science fiction, the Dhande Committee Report finds that this scheme had been rolled out in 291 districts with high levels of Aadhaar registration, and Rs.5400 crore of subsidy was transferred into 28 million Aadhaar-linked bank accounts. This is about 10% of the total subsidy for the year of 2013-14, which was Rs.46,000 crore, with 120 million subscribers in all. The tangible outcomes obtained through this work were: 0.6 million duplicate connections detected, and an 18% reduction in the sale of domestic LPG cylinders.

It took years to align all the stakeholders - the Oil Marketing Companies, Banks, National Payments Corporation of India, UIDAI, Ministry of Petroleum and Natural Gas, the Ministry of Finance, the distributors - to develop the IT systems, processes, exceptions, training materials, etc. Today, this is a scheme that can be rolled out at scale, after one signature on a green sheet by the Petroleum minister. Conservatively, this signature can deliver a saving of Rs.10,000 crore within 2 years.

Today, the private sector cannot enter the domestic LPG business, since the subsidies are funded as under-recovery by the Ministry of Petroleum and Natural Gas, and this is available to the Government owned Oil and Marketing Companies. Once LPG is sold to the customers at market price, it also allows for the entry of the private sector in this business, since the subsidy is directly transferred to consumers. There has been very little innovation in this business due to lack of competition. We will most likely see more investment in LPG import terminals, innovations such as LPG cylinders made from lighter materials, and operational improvements such as in logistics as the sector sees higher competition. Consumers will benefit with lower prices and better service if there with more competition. No signatures are required for this to happen!

Fertiliser subsidy

The same report also outlines a solution for fertiliser subsidy based on the same principles. The size of the fertiliser ecosystem is the same as that of LPG. While 120 million consumers benefit from LPG subsidy, there are about 100 million farmers who benefit from subsidised fertilisers. There are major differences though. LPG is largely sold in dense urban areas, whereas fertilisers have to delivered in sparsely populated rural areas. The distribution of LPG is carried out by Oil and Marketing Companies that have fully computerised operations across the country, and directly appoint their own distributors. In the case of fertilisers, the production and imports is mostly in the private sector, which largely receives the subsidy at source. The Central Government administers the movement of fertilisers up to the district level. Beyond that, the State Government's Department of Agriculture takes over, and different States have different distribution models.

Every aspect of fertiliser manufacturing is controlled and subsidised. Given the importance of food security, even inefficiencies are tolerated to a great extent. Take the case of Urea, which is manufactured from both, natural gas and Naphtha, with natural gas being significantly cheaper. However, natural gas pipelines are not available to factories in the south, which continue to use Naphtha, and the Government covers the additional cost. Not only is the price of Urea controlled, but so is the supply of natural gas (yes, fertiliser manufacturing gets priority when there are disruptions in natural gas imports or production), movement, allocation of railway carriages, freight subsidy, etc. There has been no investment in this sector in over a decade, and no technological improvements due to the cost-plus model of manufacturing.

As a result, we live in a society today, where people camping for iphones overnight are cheered, but farmers camping overnight for fertilisers get hell. Here is an interview with a farmer in Uttar Pradesh that sums up all the problems with fertiliser subsidy.

The subsidy on fertilisers has cost us close to Rs.100,000 crore in 2013-14. India has the largest subsidy in place worldwide, which leads to overuse of urea that decreases soil quality, and far too much control in the manufacturing and distribution that leads to perennial shortages and rampant black marketing. (See page 42 of Chapter 2 of the 2014 Economic Survey from the Ministry of Finance).

The savings in the problem of fertiliser subsidy can be conservatively estimated at Rs.20,000 crore per year. However, the implementation is a lot more challenging than the LPG case, due to involvement of the Central and State Governments, a less technologically skilled ecosystem, and the geographical spread of the solution, the grip of co-operatives in many states, etc. At the same time, just because it is difficult, this does not mean it cannot be done.

If Urea is fully decontrolled, we can expect entry of the private sector. Selling at market prices will get rid of the black marketing, and higher customer service levels will emerge from multiple producers competing for customers.

One possible way to deal with fertiliser subsidy is to eliminate it altogether, and instead adjust the higher input costs as part of the Government procurement of foodgrains. In the same way, many other input subsidies such as electricity and water subsidies offered by the state governments can be eliminated altogether and adjusted in procurement.

Reforming the PDS and Kerosene Subsidy

Many of the ideas above can also be implemented in the PDS, where the food subsidy is on the order of Rs.60,000 crore. The Report of the Task Force on an IT strategy for PDS also chaired by Nandan Nilekani provides a comprehensive set of steps to reform the PDS.

The kerosene subsidy is also administered by the State Governments, who receive subsidised kerosene from the Centre. Both, food and kerosene subsidy require better administration.

Again, by Aadhaar-linking and administering these subsidies directly into the bank accounts of the beneficiaries, there are significant gains possible. The beneficiaries can then procure foodgrains from any retail shop or grocer in the country, which has its back-end tied into the subsidy administration platform as outlined in the above report.

The expected savings from these initiatives can be on the order of Rs.20,000 crore.

Payments

An electronic payment architecture for administering Aadhaar-linked subsidies and payments is the backbone of the entire idea. This has already been put in place for purposes of LPG subsidy, and the same architecture can be leveraged for all other subsidies and entitlements.

The ideas behind linking Aadhaar and payments are detailed in the Report on Aadhaar-enabled payment infrastructure. Translating these into implementation gave the following institutional infrastructure:

• Aadhaar Payments Bridge, operated by National Payments Corporation of India. This is a back-end payments platform through which payments can be sent to bank accounts simply on the basis of the Aadhaar number. This system worked, on scale, for the LPG subsidy transfer.
• The MicroATM device design and interoperable network through which any shop owner with a mobile phone and biometric reader can become a Business Correspondent. The specifications were designed by an RBI appointed committee and have full stakeholder acceptance, that includes the Indian Banks Association, all banks, IDRBT, and UIDAI. Without issuing any token such as debit cards or mobile phone linkage, anyone in the country can access their accounts simply with their Aadhaar number and biometric authentication. This is working, on scale, in Andhra Pradesh for MGNREGS payments by India Post. A national rollout can be carried out in a matter of months with a decision from the Department of Financial Services as part of the Jan Dhan scheme.
• The Aadhaar e-KYC service provides electronic KYC for opening of bank accounts and satisfying KYC requirements in any domain.

Every government scheme -- from the MGNREGS, every form of social security pension, Janani Suraksha Yojana, scholarships, and payments to para-workers such as Aanganwadi workers and Asha workers -- can be routed through these payment. These form of payments add up to roughly Rs.100,000 crore. We may guess that Rs.25,000 crore will be saved through computerisation and elimination of fakes and ghosts.

Conclusion

These calculations suggest that it is feasible to save Rs.75,000 crore per year, by fully utilising these ideas and institutional infrastructure. Achieving important change in India is about this two part process: (a) going after big ideas that can move the needle and then (b) building State capacity for the institutional machinery which will make these ideas happen. We fail when we stick to small ideas and we fail when we fail to back big ideas with execution.

The work described above took place over a period of three years at UIDAI, under the leadership of Nandan Nilekani. I was part of the secretariat. The behind-the-scenes stories, and more, are going to be in a book Rebooting Government, that is presently being written by Nandan Nilekani and me.

The fiscal correction that India requires is feasible: Aadhaar and subsidy reform holds the key

The size of the task

Last year (i.e. 2013-14 RE), the fiscal deficit was 4.6% of GDP. The fiscal deficit budgeted for 2014-15 is 4.1% of GDP. The budget speech has said that the target for 2015-16 is 3.6% and then the target for 2016-17 is 3% of GDP. For India to achieve macroeconomic stability, this fiscal contraction is extremely important.

How are we going to get this overall gain of 1.6 percentage points of GDP from 2013-14 till 2016-17? The international experience suggests that sustained fiscal corrections are dominated by reduced expenditure; attempts at increased tax revenues tend to peter out as the economy changes its behaviour in response to short-termist tax measures. Hence, we have to focus upon expenditure reductions.

How might we get an expenditure reduction of 1.6 percentage points? Will it be done by doing a little bit here and a little bit there? The trouble is: 1.6 percentage points of GDP is a full Rs.2,06,026 crore (i.e. Rs.2.06 trillion or $33 billion). Minor initiatives will not move the needle. Any one initiative which yields an impact of below Rs.10,000 crore is not a big element of this task. What this requires is the pursuit of qualitative change.

Aadhaar offers a stab at the task

In November 2012, we at the Macro/Finance Group of NIPFP had done a cost-benefit analysis of UIDAI. At the time, the key focus was on the question: Is the construction of UIDAI an NPV-positive project? The answer of this calculation was in the affirmative. The extremely conservative estimates made in that calculation are revealing about the far-reaching consequences of Aadhaar for improvements in numerous expenditure programs. A big area for focus is on better engineering, and reforming, subsidy programs. We should think about it in three parts:

1. Superficial change: just add biometric authentication. The first and easy area for progress is the removal of duplicates (i.e. payment to the same person twice) and ghosts (i.e. payment to a non-existent person). This is low hanging fruit and only requires systems engineering of existing programs using UIDAI. At this stage, nothing changes on the working of the existing program. People continue to buy subsidised LPG through the existing subsidy program; there’s just a biometric check which establishes that the same person is not buying many cylinders. NREGA continues to operate; we just use Aadhaar to eliminate ghosts and duplicate payments.
   
   
2. Deeper change: Commodity-specific subsidies continue, but transfers are in cash. The second stage is deeper changes in the design of the program. As an example, consider the LPG subsidy. Progress had begun with direct benefit transfer for LPG (“DBTL”). In 289 districts, consumers got cash of Rs.435 a month into their bank accounts when they purchased LPG at the market rate. This program was working; Rs.5,400 crore was transferred into 28 million accounts. Unfortunately, the UPA government lost nerve and on 30 January 2014, this initiative was shut down.
   
   
3. Eliminating commodity linked and other subsidies, and doing income support. Once enough people are plugged into Aadhaar-enabled payments, it becomes possible to replace commodity-linked subsidies by a cash subsidy. This is more efficient as the government would not distort commodity markets or intrude on the preferences of households. Government would empower poor people with money and not get into decisions about whether consuming LPG is a good thing. The construction of such a cash-based subsidy involves its own design choices. This design work can start now, and one year from now, Aadhaar adoption will be on a scale large enough to support implementation.
   

All this was quite novel a few years ago, but by now these ideas are ripe for implementation. The policy analysis and workplan documents are ready on the fertiliser and fuel subsidy, use of Aadhaar for large-scale payments infrastructure, and restarting DBT for LPG.

 The low hanging fruit from Aadhaar adoption in the implementation of subsidies works out to around Rs.75,000 crore a year. While this does not take us all the way to the required Rs.2,06,026 crore, this is big enough to move the needle in a way that tinkering at the margins is not. Re-engineering subsidy programs using Aadhaar also sets the stage, and changes the political possibilities, for deeper subsidy reform (e.g. capping the number of cylinders per household, or kilograms of subsidised fertiliser per farmer) through which the remainder of the required reduction in expenditure can be obtained.

The early initiatives which can be easily rolled out are reviving the DBTL (that was done for LPG) and using the same framework for Kerosene, Fertiliser and Food. Alongside this, state governments can also use DBT for water and electricity subsidies, which will help free up fiscal resources at the state level. As with DBT for LPG: when the household pays a water or electricity bill, the subsidy would show up in the household’s bank account.

DBT can help in all government to person payments including : MNREGA, scholarships, salaries, pensions. It can help in delivering stipends and incentives to the 1-2 million contract workers associated with the government: SSA school teachers, anganwadi workers, ASHA workers etc. The WTO may require India to put an end to procurement from farmers; we can shift to delivering cash to farmers using DBT.

 It is important to remember that every time we shift from a price-based subsidy to an income support, this simultaneously yields an impact of GDP growth, as the distortions associated with price-based subsidies are removed. Hence, such an approach to reform simultaneously hits the numerator (fiscal deficit measured in rupees) and the denominator (GDP), and thus gives a bigger bang for the buck.

A few minor things or grand schemes?

To summarise, Aadhaar is the big idea around which we can take a stab at the required 1.6 percentage points of GDP of a reduction in expenditure by 2016-17. This generates cost savings right away, and sets the stage for deeper subsidy reform which will generate the remainder of the required fiscal correction. Aadhaar has been constructed and is ready to go. The BJP government has reaffirmed its interest in continuing with this program. What a difference a few years makes: Aadhaar was viewed as a complex, risky, new system, but now it’s a big working system:

• 670 million Aadhaar numbers have been issued, and the system is at its point of inflection into near-complete coverage of the poor people who would be beneficiaries of subsidies.
  
• A few thousand crore have been transferred through Aadhaar DBT.
  
• Over 60 million bank accounts are linked to Aadhaar.
  
• Several million authentications have been done so this is also a proven capability.
  
• Jan Dhan Yojana will use Aadhaar e-KYC, which is a statement of the maturity of this capability.
  
• Jan Dhan Yojana, as presently envisaged, has many problems: it is a continuation of 60 years of failed RBI thinking on financial inclusion. But this work could be channelled into a big push for getting a Aaadhar-linked mobile-based payments mechanism to every citizen of India, which would be a pretty good thing.
  

As with all important progress in India, what matters is obtaining execution on grand schemes, and not tinkering at the margin. Our present ways in public administration are broken: we need to think big, and implement new systems. The centrepiece of our journey is implementing five big transformational projects: Aadhaar, the Goods and Services Tax, the Indian Financial Code, the Direct Taxes Code, and the Delhi-Mumbai Industrial Corridor. These are the five initiatives where the analysis and thinking is complete, and we’re ripe for execution. They are big enough to move the needle for the Republic.

For many bureaucrats, it is far more comfortable living around little initiatives, and being fashionably cynical about grand schemes. The little stuff is, however, a bad use of top management time, and becomes irrelevant in a few years. A more intellectual perspective shows us, by looking back into 20 years, that it was only the grand schemes that mattered.

India macro policy review

On 19 November, we have a day-long meeting, India Macro Policy Review at NIPFP. All are welcome.

Rethinking the Statutory Liquidity Ratio (SLR) in Indian banking

by Harsh Vardhan.

The CEO of a leading bank recently caused a flutter in the banking community by demanding the abolition of the Cash Reserve Ratio (CRR). RBI has promptly appointed a committee to look at this issue. The reserve ratios, CRR and SLR (Statutory Liquidity Reserve), are an important feature of Indian banking regulation. Alongside the debate about CRR, and new thinking about how monetary policy should be conducted, we should also review the SLR. SLR is a much bigger burden on the banking system and has no role in monetary policy.

What is SLR?

SLR is the requirement imposed by the regulator on commercial banks that compels them to invest a percentage (currently 24%) of their Net Time and Demand Liabilities (NDTL) in approved government securities. Through this, today, 24% all the resources - deposits and borrowings - mobilised by commercial banks are invested in government securities. Currently bank deposits and borrowings are Rs.7 trillion which means that SLR places Rs.1.8 trillion into purchases of government securities. SLR creates a significant captive source of financing its borrowing program. This has three important implications:

1. SLR reduces the resources available for commercial lending by banks. Every rupee deployed in SLR is a rupee not invested in a private enterprise that needs capital. There is no free lunch: when capital given to the government, it comes at the cost of capital available to the private sector. Any reduction in the SLR (as in the CRR) will yield more capital for the Indian private sector. It is hence important to critically analyse both.
2. By creating a large captive source of deficit financing, SLR effectively subsidises government at the cost of savers and commercial borrowers. When a government has to borrow at a competitive rate in the market, the market exerts a check on irresponsible fiscal behavior of the government. When there is a large captive source of borrowing, the government is shielded from the pressures of the bond market and is more likely to engage in fiscal imprudence.
3. Such a large scale preemption of savings by the government through SLR fundamentally distorts the interest rate structure in the economy by artificially depressing the yield curve. This complicates the pricing of all assets in the economy.

If we want to "right-size" SLR we have to ask some important questions:

1. What is the rationale for imposing SLR?
2. What is the right level of SLR, that is consistent with this rationale and does not result in preemption of resources from the banking system?
3. Are there other conditions that need to be imposed on SLR so that it achieves the objectives?

The rationale for SLR

What is the conceptual foundation for the regulator to impose SLR? The answer is: prudence. Banks raise public deposits with a promise to redeem them at par or more. To reduce the risk of the portfolio of the bank, the regulator ensures through SLR that at least some part is deployed in the safest assets available. But if prudence is the reason, what is the right level of such reserves that will ensure adequate prudence? Could it be that imposing a requirement as high as 24% is beyond prudence, and is actually a means for the government to preempt savings in the economy? It is hence important to ask the next question: What SLR do we need?

 

What is the right level of the SLR?

Banks are in the business of taking risk. These risks are taken by deploying public deposits. The most potent weapon that the regulators have used against excessive risk taking is "risk capital" which the equity capital committed by the banks owners. In fact, the entire edifice of modern day bank regulation is based on provision of risk capital as a buffer against risk taking by banks. If we believe, as do most regulators, in risk capital as the buffer against risks, then it makes eminent sense for banks to hold this capital safely. This would logically lead us to conclude that prudence should demand that the bank's risk capital be held in very safe assets. In India, the risk capital requirement is 9% of risk assets which translates roughly to 6.5% of NDTL (given that the risk assets are typically 70% of NDTL). Therefore, the policy prescription should be: Banks must hold their entire risk capital in safe assets which should include both CRR and SLR.

Even if we assume the CRR is zero, this means that the theoretically right level of SLR would be around 6.5% of NDTL. If we scan the international landscape, this is the sort of number that we see in most countries. It is reasonable to argue that an SLR value above 6.5% of NDTL is motivated by pre-emption and not prudence. When the regulator prescribes a level of 24% for SLR, 6.5 percentage points are for prudence and the remaining 17.5 percentage points is really preemption by the government.

The composition of SLR

The next important question about SLR is about its composition - what investments should qualify as SLR investments? Currently securities issued by the sovereign (Central and State Government bonds) are the only ones that are allowed as SLR investments. But if we accept prudence as the logic for SLR, then the regulation must make sure that these investments are as safe as they can be. This raises concerns about the rating threshold and of concentration risk. If Indian government securities are rated BBB and that of New Zealand government are AAA, it makes sense for banks to hold SLR in New Zealand Govt securities. Also, there should be limits on any individual issuer of securities, reflecting the standard risk management practice followed by any portfolio manager.

The ideal SLR

Putting all the arguments above provides us an ideal construct of SLR as follows:

• SLR is imposed for the purpose of prudence and hence the operative principle is that banks should hold all the regulatory required risk capital in SLR
• The level of SLR should be consistent with the objective of prudence and anything over such a prudential level should be considered as preemption, which should be gradually eliminated.
• SLR should be invested in top rated securities available globally; furthermore there should be concentration limits on single security and issuer

Dual limits structure for SLR

In the short term, it would be hard to come close to the ideal SLR outlined above. But there are some incremental changes that can be made without fundamentally altering the current framework that could provide banks with much greater flexibility. The regulator could prescribe 2 separate limits as follows:

• L1: is the minimum level of SLR that a bank would normally maintain
• L2: "core" SLR - a minimum below L1 that the banks can go down on SLR as long as the difference is only through repo arrangement on SLR with another bank

What does this mean? Let us assume that L1 is pegged at the currently prescribed level of 24%. We then define another limit, L2, which is closer to the prudential requirement of 6.5%. For simplicity, let us assume that L2 is set at 10%. This policy would demand that all banks maintain SLR at 24% but could go down this level upto 10% if and only if they enter into a repurchase agreement (repo) with another bank. Such a policy will mean that the banking system as a whole will continue to hold 24% SLR and so the government will continue to have access to this captive source of funding deficit. However, individual banks would be able to go down to lower levels if they have commercially viable opportunities to do so. Without diluting the overall investment by the banking system in government securities, it would provide significant flexibility to individual banks on commercial lending. In this respect, it is analogous to the idea of tradeable certificates for priority sector lending.

Should government capitalise public sector banks?

by Harsh Vardhan.

What would you say if someone was borrowing money at 8% and investing it to earn around 3%? "Uninformed!", "financially illiterate!" or even outright "foolish"! And yet this is what our government has been doing with trillions of rupees over the last many years and has committed to continue to do so in the future. The process by which this is done is called capitalisation of public sector (PS) banks. Such capitalization is not only a bad idea economically as it puts enormous stress on the government resources, but also one which affects that behavior of banks and hence the robustness of the whole banking sector.

Commercial banks need capital to grow. Capital adequacy requirements ask all banks to keep a minimum amount of shareholder capital in proportion to their balance sheet size. Currently, in India this requirement is 9% of "risk weighted assets" of banks. Roughly, it means that banks are expected to have equity capital which is 9% of their commercial loans.

As banks grow their business, their risk weighted assets also grow. This means that banks has to increase their capital base in line with the growth of their loan book. Such increase in capital can come from exactly two sources - retained profits that are added to the capital base, or fresh infusion of capital from shareholders (old or new). In India, given the overall profitability of the banks (~1.1% return on assets) and the amount of dividend that they pay (~20%) of post-tax profits, banks do not have enough retained profits to support their business growth. Therefore, every now and then, they go to shareholders to raise fresh capital.

PS banks pose a peculiar challenge for the government. Being the majority owner of these banks and having committed to stay the majority owner, government has to infuse capital into these banks proportional to its ownership stake. Since the government wants to maintain its ownership at 51%, it has to supply atleast 51% of the fresh capital that PS banks need. RBI governor Dr. Subbarao, in a recent speech, said that the capital infusion by government into PS banks over the next decade will be of the order of Rs.0.9 trillion. I have read estimates of other analysts where this number is as high as Rs.2.50 trillion. These estimates depend on the assumptions one makes about a number of factors - the rate of growth of banks (which in turn depends on the growth of the overall economy), the profitability of banks, their dividend policy, their ability to raise other forms of capital (especially tier II capital), regulatory requirements on capital, etc. No matter how you estimate it, the number is very large. In other words, the government will be compelled to invest a very large amount of capital into PS banks over coming years.

Why is this a problem? Let’s look at the some simple public finance issues. India is in a deep fiscal crisis, and it is not easy to find trillions of rupees to put into PS banks. If such resources were injected into PS banks, it is not conducive to healthy public finance, since these injections are not a good deal for the government. The Indian government currently borrows long term money at over 8%. The dividend yield on PS banks shares has been between 2% and 3% over the last decade. This means that the government earns between 2% and 3% on its investments in PS banks. There is a 5% “negative carry” or loss that government bears on these investments.

A private investor also earns a low dividend yield from investing in PS banks, but can benefit from capital gains - a potential increase in the value of shares which the investor can obtain when she sells the shares. Government has never sold shares of PS banks (except when it initially listed some banks) and will not do so if it has to maintain majority ownership which is its stated policy. Hence, for the government, the financial analysis of a proposal to put money into PS banks should hinge on a comparison between the flow of dividends versus the cost of borrowing.

Capitalisation of PS banks is, thus, bad for government finances. It's a double whammy! On the one had government has to raise vast resources to be invested into banks and then carries a loss of around ~5% on these investments year after year.

Ownership and behavior of banks

Government capitalisation of PS banks is not just a fiscal challenge. It also impacts the competitive dynamics of the banking industry. Most privately owned banks are under constant scrutiny of investors and analysts. When they go to external investors for raising capital, they have to satisfy these investors on number of critical aspects of the business - profitability and its sustainability, efficiency of capital use, quality of management team, cost efficiency, etc. In other words, private banks face a market test; they do not get capital for free. Only well run private banks get equity capital that is required for growth.

None of these questions get asked when government puts capital into a PS bank. One has never heard a senior government official commenting on the Return on Asset (RoA) or Return on Equity( RoE) of PS banks. The decision to put capital into PS banks is treated as a mechanical and administrative decision. This absence of a market test has systemic consequences. PS banks have ~70% share of the Indian market. When the majority owner is asking no or very few questions on performance, and is assuring an almost unlimited supply of capital, these banks have little incentive to improve financial metrics such RoA and RoE. This hurts the overall banking industry. For example, PS banks can underprice loans compared to their private sector peers. Such behavior would migrate the whole business to lower returns. It is hard for a private bank to be profitable when facing rivals that are not concerned about return on capital.

Misplaced obsession with majority ownership

The source of this whole capitalisation issue is the government's obsession with retaining majority (over 51%) ownership of PS banks. This is often explained in terms of the need to maintain the "public sector character" of these banks. While there may be a separate debate on whether we need to maintain public sector character for all the 25 plus PS banks, the fact is that the government does not need majority ownership to achieve this objective.

  All PS banks are not companies under the Companies Act. The notion of 51% giving majority control is enshrined in the Companies Act. PS banks were created under the Nationalisation Act (SBI has its own SBI Act). The Nationalisation Act provides the government untrammelled control over these bank. While it does prescribe 51% government ownership in the PS banks, the control of government is independent of the level of its ownership. Furthermore, there is a limit of a 5% (10% with prior approval of the RBI) stake owned by any single shareholder in all banks. There is no chance, therefore, of any external shareholder acquiring control in these banks. Even relatively minor changes to the functioning of PS banks require approval of the parliament. Where is then the question of diluting the public sector character if the government ownership were to drop to, let's say 26%, which is the threshold for "significant" minority stake in a company?

In the long run, therefore, it makes no sense for the government to commit itself to the capitalisation of PS banks. Precious government resources can be better deployed in critical areas (such as power transmission and distribution) where private capital on large scale is hard to come by. In the medium term, it can use tactical measures such as merging banks where it has significantly high ownership with those where the ownership is already down to 51%. But these tactics will not solve the issue structurally. The only long term solution is to give up the majority obsession, explain to all the stakeholders the fallacy of this obsession and the resulting pressure on public finance, build a political consensus to enact necessary legislative changes and then dilute down to a reasonable level.

Evaluating responses to India's macroeconomic crisis

by Shubho Roy and Ajay Shah.

The macroeconomic setting

India's macroeconomic woes consist of high inflation, low GDP growth and a drop in asset prices. The loss of momentum is visible in the seasonally adjusted data:

Indicator	Early 2009	Latest
GDP growth (QoQ, saar)	9.83 Q2-2009	4.25 Q4-2011
Inflation (CPI-IW, pop, saar, 3mma)	7.5 Feb 2009	12.9 Mar 2012
INR/USD	48 Jan 2009	56 May 2012

The picture is not uniformly bleak. The most important asset price of the economy, Nifty, has not dropped across this period. On 1 January 2009, Nifty was at 3033. Today, it is at 4920, which is a good 62% higher. More generally, stock prices have held up rather well so far. The trailing P/E of the broad market index, the CMIE Cospi, stands at 17.3, while the median value across its full history (from 6/1990 to 4/2012) is 17.83. We may think that conditions in India are difficult, but the stock market is saying that they're roughly median conditions in terms of the outlook for earnings growth.

The current account deficit

In recent years, the fiscal condition of the government + PSUs has worsened. This has led to a large gap between savings and investment. The worsening in public finance has diminished savings. There is an accounting identity: The gap between savings and investment is the amount of capital that has to be imported. This is the current account deficit. We have a capital shortfall within India, so we are importing capital.

It is likely that in the coming year, we will have a current account deficit of 4% of GDP, or $80 billion a year, or Rs.1700 crore a day. This means that we have to worry about how foreign capital views India. Under these conditions, if there is even a short hiccup in capital inflows (as appears to have come about after the government proposed to modify the Mauritius route, and more generally with the problems of governance in India), it yields sharp rupee depreciation.

We import a lot of capital; government policy actions interrupt that flow of capital; the rupee depreciates. This is not mis-behaviour of the financial system. The system is not malfunctioning; it is behaving as it should.

What should the responses be?

There are five sensible paths for government to take, in this situation:

1. We need to see that at heart, this is a problem of macroeconomics. The root cause of the current account deficit is the fiscal deficit. If we want a lower CAD, we need a lower fiscal deficit.
2. To ensure the smooth flow of Rs.1700 crore a day into the country, we should not spook foreign investors. We should not interfere with the de facto residence-based taxation framework which India is giving foreign investors, as long as they come through Mauritius. This policy framework is, in fact, in India's best interests.
3. Deeper problems about the loss of confidence of foreign investors, owing to governance problems, need to be solved by strengthening governance. They are important (do not ignore them), but there is no quick fix other than improving governance.
4. In the face of these difficulties, it would make little sense for RBI to trade in the currency market, to try to block the rupee depreciation. There is good reason for rupee depreciation; the currency market is doing a pretty good job of translating the fundamentals into a price. And, in any case, even if RBI desired to do something about it, its weapons are puny when compared with the size of the currency market and the Indian economy.
5. It is an opportune time to continue with the liberalisation of the capital account. However, it is useful to think deeply about how to proceed with this. Some kinds of liberalisation can be dangerous. It is important to think about sequencing, and at all times, to worry about unhedged currency exposure. A good deal of expertise has built up on the subject, through the Raghuram Rajan Committee and the UK Sinha Working Group which worked out the medium-term and short-term sequencing of reform.

An evaluation of what has been done

There are three features of recent policy responses which appear to be on track:

1. By and large, RBI's trading on the currency market appears to be at a low scale, nearing zero in many recent months. This is wise. It increases respect for the brainpower at RBI.
2. The government raised the price of petrol, so as to cut the fiscal deficit. This increases respect for the brainpower and political capabilities of the government.
3. The government decided to defer the attack on the Mauritius treaty by a year (though not to shelve it altogether). In the absence of clear policy statements about the importance of residence-based taxation, this shelving does not increase respect for the government.

Apart from these three good moves, a slew of dubious ideas have been afoot.

A. Enlarging the scope for dollar-denominated borrowing by Indian firms

On 20^th April, 2012: external Commercial Borrowings regulations were amended to:

1. Increase the limit on power companies to refinance their borrowings in Rupees with foreign currency loans (also called External Commercial Borrowings or ECBs).
2. Allow companies to borrow in foreign exchange to make capital expenditure for maintenance and operations of toll systems (See here)
3. Companies were allowed to refinance their ECBs with subsequent ECBs at higher interest rates (See here).

Evaluation: Do we really want Indian firms to hold dollar denominated debt? In particular, firms in the field of infrastructure who have cashflows in rupees? Sensible firm should see the high ex ante currency volatility and stay away from borrowing in dollars without hedging; so the impact upon capital flows will be small at best. And firms that do borrow in dollars and keep it unhedged are probably not going to fare well.

B. Enlarging the scope for dollar-denominated borrowing by banks

On 4^th May, 2012: The maximum interest payable on forex deposits by NRIs in Indian banks was increased (See here):

1. For deposits between 1 to 3 years the increase was 75 basis points.
2. For deposits between 3 to 5 years the increase was 175 basis points.

Evaluation: Banks are disaster-prone 19th century institutions. Do we really want them to hold more unhedged foreign currency exposure? Of all places in the economy, this is the worst place to keep unhedged currency exposure. The wise ones will not borrow in this fashion, so the impact upon capital flows will be small at best. And the unwise ones, that borrow in dollars and keep it unhedged, are probably not going to fare well.

C. Reducing the economic freedom of exporters

On 10^th May, 2012: the right of exporters to hold foreign exchange was reduced by 50% (See here):

1. Exporters were allowed to keep their forex earnings in special accounts called EEFC accounts. They were not mandated to convert it into Rupees. This allowed them the ability to fund imports for their business without going through costly conversions.
2. Now only 50% of their export earning will be allowed to be kept in forex. The rest will be converted into Rupees against their wishes.

Evaluation: In the old India, FERA made ownership of foreign exchange an exotic and rare thing. Many businessmen in India engaged in import/export misinvoicing and tried to hold assets outside the country. In the early 1990s, C. Rangarajan's RBI embarked on a modern arrangement. Exporters were given greater economic freedom. We are now rolling the clock back by 20 years; we are tampering with current account liberalisation.

The number "50%" has not been justified in the RBI notification. Any exporter, with significant raw material import cost will now pay unnecessary transaction charges. In global trade, where every country takes the utmost effort to keep their exports competitive, any small distortion impacts on export competitiveness; this is pushing in the other direction - it is an attempt to reduce India's export competitiveness.

This is a new low in Indian economic policy. Every internationally oriented household in India will now be more keen to hold assets and liquid balances outside India, safe from the clutches of Indian capital controls. This measure will thus exacerbate capital flight and worsen the problems of the rupee. Success in the marketplace will tend to accrue to businessmen who break laws as opposed to the law-abiding ones.

D. Damaging the currency futures market

On 21^at May, 2012: restrictions were put on exchange-traded derivatives (See here):

1. The net overnight open positions that the banks hold shall not include positions in the exchanges.
2. The positions in exchanges cannot be used to offset positions in the OTC market for
3. The position of banks in currency exchanges shall be limited to $100 million or 15% of the market (whichever is lower)

Evaluation: The world over, there is a clear understanding that the exchange is a superior way to organise financial trading. When compared with the OTC market, the exchange has superior transparency and risk management. Policy makers need to continually modify policies so as to favour a migration of all standardised products away from the OTC market to the exchange-traded contracts. RBI's moves go in the wrong direction.

How do we ensure that the price on a financial market is driven by fundamentals? The answer : We must have a deep and liquid market, and a broad array of sophisticated speculators. RBI's actions are going in the exact opposite direction. They are trying to make the market illiquid. But it is in an illiquid market that we will get market inefficiencies and weird behaviour of the price. They are increasing the chance that something nutty happens on the rupee.

This circular is also a reminder about poor legal process at RBI. Every action by a regulator must articulate a rationale. Financial regulations are motivated by exactly two possibilities - consumer protection or micro-prudential regulation. The government agency that wields the power of financial regulation must show the clear rationale, describing what is the market failure that this regulation is seeking to address. The government agency must show the cost-benefit analysis, explaining why the costs of this action outweigh the benefits. As is typical of financial regulators in India today, RBI's documents show no rationale.

It is possible to conjure one conspiracy theory. The attempts at damaging the liquidity of the currency futures market should be seen in connection with previous work on damaging the liquidity of the OTC market. Perhaps there is a grand plan here. The scale of RBI's trading on the currency market is implausibly small when faced with the size of the Indian economy, with the size of India's cross-border interactions and the size of the currency market (both onshore and offshore). Perhaps these recent moves are designed to damage the liquidity of the market, so as to get to a point where RBI intervention can make an appreciable dent on the price. Perhaps the game plan is to gnaw away at the capability of the currency market through a series of moves, and then take off doing large scale manipulation of the market. If this is the game plan, it reflects very poorly on the economic policy capability at RBI. It would also generate massive profit opportunities for the speculators of the world, who would short the rupee when the large scale manipulation commences.

Rumours about other bad ideas abound. E.g. it is suggested that RBI will sell dollars to exporters directly. How is this different from selling dollars on the market?? It is suggested that the currency futures and the OTC markets should be completely cutoff by banning the arbitrage. How would this solve the macroeconomic problems which bedevil the rupee?

Microeconomic distortions are not a good way to address macroeconomic problems

What does one make of this spectacle? A simple principle worth reiterating is:

Problems rooted in macroeconomics must be addressed using macroeconomic instruments.

We got into this mess because of inappropriate fiscal and monetary policy. We need to solve these -- monetary policy must get back to the business of delivering low and stable inflation, we have to fight inflation until we see y-o-y headline inflation (i.e. CPI-IW inflation) going to the 4-to-5 per cent range. Alongside this, fiscal policy needs to correct itself. Each of these has a clear direction to move in, and movement on any one is valuable regardless of what the other does.

A big element in the picture is the loss of confidence, in the eyes of the private sector, on an array of issues ranging from ethical standards to the sophistication of fiscal, financial and monetary policy. This is an important problem and it needs to be addressed. The spectacle of a government flailing at the macro problems using micro instruments is worsening matters. Perhaps there is constant pressure to announce `new measures' to solve the problem. Deeper solutions are hard, and there is enthusiasm for `doing something' (large or small) [example].

We've seen this movie before. In the last decade, again and again, RBI tried to wield capital controls as a tool for macroeconomic policy. They failed. It is disappointing to see the lack of learning.

Some of the moves above have come out of the reflexive socialism that lurks within the Indian bureacracy. Perhaps, in a crisis environment, the ordinary immune system within each government agency, which keeps the sub-clinical socialism under check, is not working as well. This hurts from two points of view. It betrays the lack of capability of these government organisations; it reminds us that the Indian State is strewn with people who have a low knowledge of economics and a taste for dirigiste. It also reminds us of the policy risk: Precisely when the best capabilities are required (in a crisis), we seem to be slipping into the lowest quality policy initiatives.

Everyone who sees the government / RBI engaged in one ill thought out measure after another gets worried about India's future. How can a $2 trillion economy flourish while such immense powers are placed with individuals and institutions with such weak capabilities? This further damages confidence, which deepens the macroeconomic crisis.


Acknowledgements: We are grateful to Apoorva Ankur, Sumathi Chandrashekaran, Pratik Datta and Kaushalya Venkataraman for useful suggestions.

Guide to the Eurozone crisis

by Percy Mistry.

How did it happen?

The worst financial crisis in the western world for nearly 80 years broke in September 2008.

It required banking/financial systems to be supported and recapitalised by governments across the EU and in the US.

In June 2009 it became apparent that the peripheral countries of the Eurozone (Greece, Portugal, Spain and Ireland) were grossly over-indebted.

Yet in some instances (Spain) their public debt to GDP ratios happened to be lower than those of the US, France, the UK and Germany.

The continued viability of their public finances depended entirely on markets being willing to refinance them with cheap money.

But, when markets scrutinised the sustainability of their fiscal positions, they baulked from refinancing except at punitive rates.

CDS spreads (against Germany as a benchmark) of peripheral Eurozone countries (PIGS or Club Med) debt began widening relentlessly.

Global financial markets began to price in an escalating risk of partial/full voluntary/involuntary default on PIGS bonds since December 2009.

Contrary to first impressions, except for Ireland, that was a result not just of the financial crisis and bank recapitalisation demands on the fiscus.

It became apparent instead that bank recapitalisation demands on public finance were only the last straws that broke the camel's back.

Greece, Portugal, Spain and Italy, as a direct consequence of joining the Eurozone, had been running up unsustainable fiscal deficits since 2000.

Ireland had not. It suffered because the bailout of its disproportionately large banking system caused its public debt to rise astronomically.

PIGS became over-indebted despite the supposed self-imposed discipline adopted by the Eurozone of prohibiting fiscal deficits >3% of GDP.

That discipline was violated by almost all Eurozone members, beginning with France and Germany, but more egregiously by the PIGS.

To make matters worse, however, the PIGS were also running increasingly large current account deficits (with Germany, France, China).

Though countries like France (and to a lesser extent) Germany were fiscal sinners, they were at least running current account surpluses.

PIGS had access to excessively cheap public and private money available on terms totally inappropriate to their economic circumstances.

Given their inherent risks, which markets mispriced completely, their borrowing costs should have been 300-500 bp higher than Germany's.

Instead, they were virtually the same for nearly a decade. That relieved market-induced pressure on PIGS' governments to behave responsibly.

Consequently, their public expenditures after 2000 ballooned out of all proportion to their intrinsic capacity to fund them from tax revenues.

Such expenditures became almost wholly dependent on access to increasing amounts of cheap public borrowing from capital markets.

In response to access to excessively cheap money, wages in the PIGS rose across the board as did growth in public sector employment.

With the financial crisis triggering bank recapitalisation needs, on top of this unsustainable structure, the edifice began to crumble.

The first early warning signals became apparent in December 2009 but the dam broke in mid-2010 with the first Greek bailout.

How has the Eurozone crisis been handled?

Extremely ineptly; indeed very foolishly, by sophisticated Eurozone authorities (political, fiscal and monetary) that should have known better.

Eurozone leaders learned nothing from the preceding debt crises in Latin America (1982-87, 1994-95) and Asia (1997-2000).

They went through avoidable phases of serial denial that there was a structural debt (solvency) crisis that could spread via contagion.

They treated it as a liquidity crisis that could be dealt with by temporary patch-ups of additional money combined with fiscal restraint.

They reiterated their commitment to ensuring there would be no default - partial or full, voluntary or involuntary - by any Eurozone member.

They believed that their remedial measures would stop the crisis from ballooning beyond the first bailout package for Greece.

They were totally wrong. That package did nothing to convince markets that Eurozone leaders understood the nature/severity of the problem.

In fact, the inadequacy of that first bailout package -- which did not provide enough money for sufficiently long - became quickly apparent.

Eurozone leaders were fixated on debt-affected PIGS being forced to live within their means through indefinite austerity without end.

Debt recovery/sustainability models did not provide sufficient new money, or permit debt restructuring, in ways that would restore stability.

Least of all were bailout packages designed to restore growth in a conscionable period of time that would be socially/politically acceptable.

Without financial system (and borrowing cost) stability, and absent growth, debt problems can never become better. They can only worsen.

Instead, as a result of poor design, all the bailouts did (except for Ireland) was to add new debt to bad debt and reduce growth prospects.

To exemplify: In mid-2009 the debt/GDP ratio for Greece was 115% of GDP and the debt service ratio about 11% of GDP.

But, by October 2011 the debt/GDP ratio for Greece was 161% of GDP and the debt service ratio nearly 20% of GDP.

It is projected with the third bailout to rise to 185% of GDP (although debt service will be lowered to 16%) before it comes down again.

In the meantime, over the last 32 months, the Greek economy has shrunk in size by almost 17% in nominal terms. It will be 1/5 th less in 2012.

Such inane 'remedies' do not solve debt problems. They only aggravate and exacerbate them.

While behaving in this absurd fashion Eurozone leaders repeatedly asserted for two years that they would do everything in their power to:

• Maintain the credibility of the Euro while ensuring that every member stayed in the Eurozone
• Not allow any default of publicly issued bonds to occur; and
• Do everything possible to avoid contagion spreading beyond PIGS (even as it became clear that markets were worried about Italy.

Instead they achieved the exact opposite of all three objectives through their inability to understand the implications of what they were doing.

Though now contrite and claiming to have learnt a few lessons from their serial bungling over 30 months Eurozone leaders have no solution.

The EFSF facility they created is woefully underfunded. It can barely deal with financing the third Greek bailout.

The idea of leveraging it or using it as a partial guarantee facility is absurd since it would add to risk and uncertainty not resolve them.

Yet over-indebted governments (including France and Germany) would have to issue more public debt in order to fund the EFSF properly.

That would simply mean requiring their fragile, near-bankrupt, banking systems (or the ECB) or global markets to buy more Eurozone debt.

Except for Germany (and even that will be in doubt soon) the market has no appetite for taking on more Eurozone debt given its risks.

Contagion has spread from the periphery and now lodges at the core of the Eurozone economy in which Italy is the third largest member.

What could have been resolved with about 300 billion euro in additional financing in mid-2010 is now a problem that may require 2 trillion euro.

Where are we now?

Over 35 EU/Eurozone summits in 30 months have resolved nothing. They have made matters worse; despite Herculean exertions!

Right now Greece is in 'effective' default; though markets are overlooking that because of the implications of CDS contracts being triggered.

Its borrowing costs for refinancing its debt would exceed 30% if it had any access to private markets; which it does not.

Any refinancing of, or addition to, Greek debt can now only be financed by the ECB; which the Germans will not permit the ECB to do.

Meanwhile the Greek banking system is bankrupt. Indeed the entire Eurozone banking system's credibility/stability/solvency is in doubt.

Today an outstanding portfolio of about 11-12 trillion euro in Eurozone debt - of which about 80% is held by EU firms - is souring relentlessly.

About 7 trillion euro of that portfolio is sufficiently affected by contagion to require provisioning (France and Belgium may soon be added).

About 5 trillion euro of Eurozone high-risk-debt is currently held by EU banks, insurance companies, pension funds and individuals.

That sovereign debt, which is supposed to constitute the 'safest' component of any asset portfolio, now constitutes perhaps the riskiest element.

That reality inverts the whole basis of banking/financial system soundness and stability across Europe (including the UK).

It compounds the problem of calculating capital adequacy requirements for these banking systems and puts regulators in a quandary.

Ireland's bailout programme is working but could be derailed by what is happening in the rest of Europe.

Portugal's programme is not working as intended. But nobody is talking about it because it pales in comparison with Italy and Greece.

Italy's outstanding public debt will soon cross 2 trillion euro (120% of GDP) and its debt service payments amount to around 300 billion euro per year.

That is made up of about 120 billion euro in interest payments and 180 billion euro in principal repayments. Average duration is 5 years.

Public debt service in Italy now amounts to around 17% of GDP and will rise to 20% unless Italy's debt is dramatically restructured.

Italy now needs to borrow about 40 billion a month euro (gross) and about 28 billion euro a month net in private markets to refinance its debt.

The world is holding its breath with every auction of Italian public debt (3-8 billion euro per week) any of which could trigger accidental default.

The cost of refinancing Italy's public debt has risen from around 4% a year ago to around 7% now. That adds 20 billion euro a year to its debt.

Meantime the Italian economy is flat-lining and its capacity to service additional debt is diminishing despite its running a primary balance.

Banks around the world are dumping their holdings of Italian public debt but there is no buyer other than the ECB because of the risk.

The ECB's capacity to refinance Greek, Italian and Portuguese debt is limited and constrained by Germany's unwillingness to consider that.

Contagion from Italy is now beginning to affect Spain and France which is supposed to be a bulwark for the EFSF's borrowing capacity.

The resulting gridlock is pushing the entire Eurozone system toward a catastrophic denouement with a binary outcome. Either:

1. Crisis-induced progress toward fiscal union with national sovereign bonds being replaced by a single Eurozone bond with a joint/several guarantee, or
2. Sudden disorderly collapse of the Eurozone with unimaginable fallout and consequences that would trigger a global double-dip recession.

Such a recession would last for a minimum of 2-3 years and would probably be quickly followed by a similar debt crisis in the US.

The resulting fallout of disorderly Eurozone break-up could trigger a break-up or restructuring of the larger EU as well.

So where do we go from here?

With the foregoing in mind it seems absurd that the world is waiting with bated breath to see what the new technocratic governments in Greece (Papademos) and Italy (Monti) will actually achieve by way of structural reform and increased debt servicing capability in coming months.

These technocratic governments inject new credibility but lack political and social legitimacy. They have been appointed not elected.

It remains to be seen how long their technocratic legitimacy holds out without the backing of gradually earned political/social legitimacy.

The risk is that if the ministrations of these technocratic governments (which their societies believe have been imposed on them from the EU above) do not work and bear fruit relatively soon (the probability is that they won't), public patience with them will melt.

Will they be able to convince electorates to accept the inevitability of austerity without growth for the indefinite future?

The next Greek crisis is perhaps 10-12 weeks away.

The next Italian crisis could be triggered by any one of the upcoming weekly auctions of Italian government debt.

Despite these rather obvious realities, global markets deem to be reacting in dream-like hope and optimism that all will be well.

There is of course a solution at hand; and the only one that will work because all the other options seem to have been exhausted.

That option requires Germany to reconsider its refusal to bear its large share of the fiscal burden that will come with Eurozone fiscal union.

It requires political/social willingness on the part of rich northern Eurozone members to finance fiscal transfers to poorer southern members through an exponential expansion of structural funds, currently applied to help develop more rapidly the poorer regions of the EU.

Reciprocally, it requires other Eurozone countries to relinquish fiscal, and a great deal of political, sovereignty immediately; in order to assure global markets of their commitment to structural reform, restoration of competitiveness, and relentless pursuit of fiscal/monetary discipline.

It requires all unwanted national sovereign bonds of Eurozone members to be replaced by a single Eurobond that is jointly and severally guaranteed and underpinned by the weight and ability of the ECB behind it to print money if necessary to ensure that such bonds are honoured.

This solution would resolve both the over-indebtness problem of the Eurozone and the problem of banking system collapse at a single stroke.

If it were adopted the need to provide for risky Eurozone debt and recapitalise (yet again) the EU banking system would disappear.

Yet, this is the one solution that keeps being discarded because of legitimate German constitutional, judicial and political constraints.

They inhibit movement in such a direction regardless of the consequences for the Eurozone, the EU, and mostly Germany itself.

It is like witnessing a repeat of 1939; not of conquest but of mindless destruction. But, this time with money rather than tanks being involved.

If that only workable solution continues to be discarded, the other possibility that will manifest itself is the disorderly break-up of the Eurozone; simply because its orderly break-up defies contemplation and imagination.

Talk of Greece being ejected from the Eurozone, or of Germany departing from it voluntarily, is fanciful simply because neither can afford to bear the costs of the consequences that will follow, regardless of what their populations and political leaders may believe or think (though 'thought' seems to be conspicuously absent from the process just now). Neither can their neighbours, regardless of what they may think.

Yet it is not unimaginable that a break-up will be forced on Eurozone members by global markets if the only workable solution continues to be ruled out as it seems to be repeatedly by the German Chancellor. But she has changed her mind so often the hope is she will yet again.

A disorderly break-up may result in a reversion to national currencies; which would be better than members trying to retain some semblance of the Euro through separate residual monetary unions of more compatible economies.

That would probably require four different Euros (for the super-efficient Northern economies a Baltic Euro, for the relatively efficient middling economies a Franco-Euro; for the newly acceding countries an Eastern-Euro and for the inefficient, uncompetitive Club-Med economies, a PIGS-Euro). Other than the first, none of the others would be credible for holding as reserves, or for trading significantly in global currency markets.

Finally, bear in mind that we have spoken of only the public debt problem in the Eurozone.

Should the unthinkable (but increasingly likely) disorderly break-up happen, the public debt problem will be accompanied by an unresolved private debt problem throughout the Eurozone of equally monumental proportions! That really will break the system and the banks!

Household behaviour that counteracts fiscal expansion

Suppose a government tries to boost demand in the economy by boosting the deficit.

A fascinating feature of the situation is: Households are not wood, households are not stones, but men. And being men, they will look forward, they will optimise. Households know that all government expenditure requries taxation: all that is achieved by running a deficit today is postponing taxes to tomorrow.

India's fiscal stance is now likely to lead to increased taxation in the future. We have a nice wide deficit today, but it's increasingly likely that fresh taxation will come up in the future.

A core feature of human beings is that we do not like to deal with fluctuations in our consumption. So faced with the prospect of taxation tomorrow, we are prone to cut back on consumption today.

Through this, when a government raises the deficit today, some of this effect is counteracted by households that pull back on expenditure. Raising the fiscal deficit is less expansionary than some would think.

Economists have a fancy name for this: it's called Ricardian Equivalence. This was originally thought up by David Ricardo, but made famous by Robert Barro. It is one of the many ways in which forward looking households are of essence in thinking about macroeconomics. "You are not wood, you are not stones, but men; and being men, you will optimise".

Interesting readings on the Indian budget

• Editorial in the Indian Express.
  
• Consolidation without pain! What am I missing? by Jahangir Aziz in the Business Standard.
  
• An anti-inflation budget by T. N. Ninan in the Business Standard.
  
• Sweet smell of radicalism by Surjit Bhalla in the Indian Express.

India: a nascent social democracy?

As India embarks on the early stages of middle income, there is interest in a more expansive outlay of expenditure for the government. This motivates the question: Can India now embark on constructing an array of welfare programs, which would ultimately add up to an approximation to a welfare state or a social democracy?

Vijay Kelkar and I wrote a paper Indian social democracy: The resource perspective on this question, for the 10th `Indira Gandhi Conference' which took place in New Delhi recently.

Acute need for debt management office

One element of responding to the fiscal stress that India is now facing consists of the creation of the Debt Management Office. I have an article in Financial Express titled What is the right time to build a DMO?, and there is one in Economic Times by Siddharth Shah, Chittaranjan Datar and Nirvaan Gupta titled Is India ready for debt management office?. Also see this editorial in Financial Express on the new Cash Management Bills.

Debt issuance this year, and setting up an independent debt management office

Writing in Financial Express, Mahesh Vyas and Jayanth Varma analyse the extent to which the 6.8% fiscal deficit of this year is `hard' to fund through bond issuance.

In FE today, Jayanth Varma has an article on the merits of setting up an independent debt management office, and they have an editorial on this subject.

A new perspective on how RBI might approach the DMO reform

In Mint today, Tamal Bandyopadhyay has an article Reserve Bank of India needs new clothes which has an original perspective on the establishment of the Debt Management Office:

If indeed the debt management function is taken away from RBI, I don't think it will be a big loser as now it manages some 25 functions and each can be independently run by an institution. In the past, at least five institutions have been carved out of RBI (NHB, Nabard, Exim Bank, Industrial Development Bank of India (the earlier avatar of IDBI Bank Ltd) and Unit Trust of India) and the debt office will be yet another such body.

RBI should not bother much about losing its debt management function, and instead focus on changing the organization to be in sync with the new global order.

It's the private corporate investment, stupid

The first graph in The setting for the budget speech tells the story of the importance of private corporate investment. The text there says:

The economic reforms of the early 1990s got private corporate investment up from the region of 4% to a peak of 10%. This six percentage point increase of private corporate investment generated a strong business cycle expansion.

The decline of private corporate investment back to values like 5% was the essence of the business cycle downturn of 2001-2002. After this, we have seen an immense expansion of private corporate investment -- all the way to 16%. This is the essence of the benign business cycle conditions of recent years.

The most important question that will shape business cycle conditions in 2009-10 and 2010-11 is: by how much will private corporate investment decline? It is important to see that today, each percentage point of GDP is Rs.55,000 crore, so we are discussing massive numbers. If a decline of private corporate investment takes place from 16% to 10%, then this is a reduction of demand by 6 percentage points of GDP or Rs.330,000 crore. When private corporate investment goes down, the overall impact on GDP is magnified through multiplier effects.

The shocks to GDP that are generated by these fluctuations of private corporate investment are so large that monetary or fiscal policy, as presently organised in India, can simply not counteract them. The only place where public policy can make a difference to this is to identify the policy instruments through which private corporate investment can flourish.

Some say the budget has done a fiscal stimulus by expanding the fiscal deficit by 0.8 percentage points. Others say that in tough times, it's not correct to engage in deficit reduction. These arguments have to confront the irrelevance of the direct impact of these fiscal numbers. Whether the fiscal deficit goes up by 0.8 percentage points or it goes down by 2 percentage points, these are tiny numbers when compared with the real prize: private corporate investment.

If we play things right, and persuade domestic and foreign investors that India is on the right track, then this would perhaps add five to ten percentage points to the investment/GDP ratio, which drowns out a 2 percentage points of GDP reduction in the fiscal deficit which (in my opinion) is a critical element of the policy stance required to reassure the private sector that India is on the right track.. And if we play things wrong, then a five to ten percentage points of GDP reduction in private corporate investment will drown out a 0.8 percentage points of GDP fiscal stimulus.

The key message: focus on private corporate investment, not on either monetary or fiscal stimulus. India does not have the institutional capability to use monetary or fiscal policy to do business cycle stabilisation on the scale that we are seeing in the West. Let us not transplant the intuition and rhythm of policy that we see in the US and the UK into our setting, where we have dysfunctional institutions. In the medium term, we need to do fiscal, financial and monetary institution building so as to have that kind of apparatus. In the short term, the only real lever we have, that can stabilise the economy, is the outlook for economic reforms.

What determines private corporate investment?

Suppose you spend Rs.100 to build a factory, and suppose (for the moment) that this is all-equity financing. Suppose you take the company public and the market gives you a valuation of Rs.200. In other words, the hard work that you put in to build the business using Rs.100 of risk capital has created wealth of Rs.100.

This ratio -- the market price of a project divided by the cost of building it -- is called Tobin's `Q'. When Q > 1, CEOs and entrepreneurs would feel like building projects. The bigger Q is, when it's beyond 1, the bigger the incentive to engage in investment. When Q is near 1 or below it, the incentive to invest withers away. The sword of entrepreneurship is guided by the eyes that seek out high valuations.

The price to book ratio of the broad market is a poor man's Tobin's Q. It is a poor estimator because while the numerator (market cap of Nifty) is correct, the denominator (the replacement cost of building the Nifty companies) is only roughly approximated by the book value of the Nifty companies.

This argument emphasises the clear and direct link between stock prices and the investment optimism of CEOs. When stock prices are high, CEOs are more likely to build factories, and vice versa. In other words, the path to high private corporate investment runs through high stock prices.

The chatter on television and newspapers frequently says "Oh, but a budget must not only be judged by what it does to stock prices" or "Oh, but the stock market does not understand these things". I would emphasise two points. First, whether the stock market is right or wrong, it is the driver of how CEOs behave. So regardless of what we think about the quality of information processing of the stock market, it matters. Whether we like it or not, the stock market drives the resource allocation. Second, there is an enormous academic literature which gives us reason to respect the sophistication and capability of the stock market in information processing. The future is of course un-knowable, and every forecast of the future will have a substantial zone of error. But there are few better estimators of what might come, than the pooling of knowledge and opinion of millions of financial market participants in an open, transparent setting.

So what are stock prices saying?

The graph (click on it to see it more clearly) superposes Nifty and the S&P 500 indexes. Both indexes start at 100 on 1 May 2009. The S&P 500 index shows little movement, which suggests that the dominant story lies in domestic events.

When the election results came out, Nifty achieved values like 118 in the graph, i.e. 18% up compared with pre-election conditions. This was good news for Tobin's Q and thus private corporate investment. It was the best news possible for the outlook for business cycle conditions.

Why did we feel optimistic at the time? It was felt that two scenarios had been avoided: the scenario of confused / weak governance with attendant political problems, and the scenario of a UPA-1 where economic reforms were blocked by the CPI(M). The hope that UPA-2 would do better gave us higher stock prices, going all the way to 27% up compared with pre-election levels.

We've had a sharp decline, from indexed values of 127 to an indexed value of 112; a decline of 12%. In other words, a bit less than half the gains have been erased. This is not good for Tobin's Q and hence not good for the outlook for private corporate investment and hence not good for the outlook for business cycle conditions.

Worldwide, there has been a political shift away from left parties given that voters are nervous about economics and want top quality leadership in terms of economic policy. When the going gets tough, voters turn to The Man. In India also, this should be seen in the context of a long-term secular decline of the vote share of the Left: both trend and cycle are going against the left. A key reason why the UPA-1 won the election was the benign business cycle conditions that prevailed 2004-2009, and the fiscal bounty that came with it. Conversely, things will be very painful in political terms if business cycle conditions go back to 2001-02 levels. It is odd for India to have shifted towards giving more power to the left within the Congress at a time like this.

Early in this blog post, I show the most recent available data which proxies for private corporate investment: the monthly time-series for IIP capital goods and for imports of capital goods. Both these are quite dated. In a few months, we will know what happened to the month-on-month changes of these two series in July and August, which would reflect the consequences of the budget speech.