Repeal 100 laws

An earlier version of this appeared on qz.com two days ago.

Fixing the laws is fixing the Republic

Badly drafted laws are at the heart of the failures of government in India. All too often, in India, laws feature sloppy drafting (inducing legal risk), have vague objectives (hampering accountability), and give sweeping powers (inviting abuse). Of particular importance is the role of sloppy drafting coupled with absence of accountability in generating arbitrary power in the hands of the executive. You have to `respect' the executive because it has arbitrary power.

Today there is a thicket of nearly 2,000 central laws, alongside hundreds of state laws, processes, rules and regulations, The Gazette of India fares badly on publishing central legislations, making it impossible for citizens to know all the laws through which government has powers over them. Everyday life has become a minefield: a person never quite knows what laws he is violating.

Remedying this situation requires large scale rewriting and cleaning of the statute books. The first step is outright repeal of obsolete and anachronistic laws. The second is creating a new wave of well-drafted laws which clean up one sector at a time. A well-drafted law is precise, principles-based and will make sense for a long horizon. One example of this is the Indian Financial Code, which aims to replace all existing financial law. Drafting high quality law is a complex and time-consuming process.

Both strategies -- outright repeal and new drafting -- are required to clear the thicket, reduce complexity, uncertainty, mis-governance and opportunities for rent seeking, and ultimately to put the Republic on a sound foundation.

Three groups of laws that require fixing

Three groups of laws are of prime importance in cleaning up the undergrowth:

1. There are laws from the colonial era which are irrelevant or misplaced today, as the world has changed. Some of these were specifically enacted to curb the independence movement.
2. In particular, during the Second World War, many laws were passed which reflected the exigencies of the war. In numerous areas, freedoms of Indians were taken away to make it convenient for the British war effort.
3. The laws from the socialist period, roughly 1950 to 1980, where the government sought to achieve a dominant role in the economy. Many times, the dirigisme which was initiated as a wartime measure ossified into a system of control under socialism. The years around the Emergency in particular had laws which gave a tremendous increase of State power, the after effects of which are still plaguing the country.

The zone of careful rewrite

While all the laws under these three categories merit review, in many cases, outright repeal is neither feasible nor desirable. Three examples are instructive:

1. The Forward Contracts Regulation Act of 1952 has as its objective the prohibition of options trading. This is not an objective that we wish to pursue today. However, the solution does not lie in a simple repeal of this Act; what is required is a complex drafting of a new law (i.e. the Indian Financial Code).
2. The RBI Act, 1934, was proposed by the British as a `temporary measure'. It is a badly drafted legislation, and has given us an under-performing central bank, but the solution is not a simple repeal but the complex drafting of a new law (the Indian Financial Code).
3. There are huge problems with the Indian Penal Code in areas such as freedom of speech. In a sense, the IPC of 1860 (written three years after the mutiny) is incompatible with the Constitution of India when it proposes to imprison a man for committing the crime of speaking. But this is not a simple repeal. What is required is a deeper rewrite of criminal law - e.g. by setting up a Criminal Justice Legislative Reforms Commission a la FSLRC.

The zone of outright repeal

In 2014, a collaborative project was initiated between three organisations -- Centre for Civil Society, Vidhi Centre for Legal Policy and the Macro/Finance Group at the National Institute of Public Finance and Policy -- that aimed to identify 100 laws that can be simply repealed. This initiative came at the back of the new government's undertaking to clean the statute books. The initiative identified laws that are completely out of touch with today's India, where almost everyone would agree that they do not belong, and where there are no complexities other than a simple repeal.

The report of this project has a compact presentation of each of these laws, based on thorough research. This document is a hall of shame of the 100 laws that have no reason to exist. Once there is consensus about this work, a simple `Repeal of 100 Laws Act' can be drafted which eliminates these 100 laws.

In the past few weeks, the government has built momentum towards fulfilling its promise of repealing dated enactments -- however, these have focussed largely on low-impact house keeping repeals. This is no doubt crucial. The 100 Laws Project however, goes a step beyond -- it has assembled a package of both low impact repeal recommendations (40 of which have been included by the 20th Law Commission as part of its Legal Enactments Simplification and Streamlining project/248th Report), as well as gathered evidence to recommend repeal of high-impact laws that materially affect business climate and government effectiveness.

Achieving a modern and capable State in India undoubtedly requires more work. There are surely more than 100 laws which merit simple repeal. There are thousands of laws, which can be removed through more complex drafting projects. Most important of all is the constructive agenda, of drafting high-quality laws which create an accountable government with clarity of objectives. However, in that larger journey, this project is a useful and immediate building block.

A team of experts sifted through the landscape and chose 100 laws that are ripe for repeal. Let's look at the distribution of the date of these laws:

Distribution of the date of the 100 laws

We see a bimodal distribution with one hump at old British laws and another reflecting the period of India's socialism. The vertical lines focus us on the socialist period, 1955-1980, and the red line is the year of the Emergency, 1976. This gives us insights into the time periods which produced laws that obviously merit repeal, and may help increase the productivity of future projects which sift through laws.

World War 2 does not show up as a bump in this graph. Perhaps what is going on here is that the restrictions which were introduced here, such as capital controls, ossified into complex systems of socialist control, and resist simple repeals.

Reinvigorating the legislative process

In the past, the drafting of laws was dominated by the executive. As an example, the Ministry of Rural Development drafted the National Rural Employment Guarantee Act, 2005. The founding team of SEBI drafted the SEBI Act, and RBI staff have repeatedly had a role in drafting amendments to the RBI Act. This method of drafting generates a bias in favour of sweeping powers and low accountability.

For the health of the Republic, it is important to have independent voices involved in drafting and critiquing laws, and to create public debate on the substance and impact of new and old laws. In recent years, we are starting to see the evolution of think tanks away from traditional economic policy analysis towards a greater understanding of, and an involvement in, the legislative process. Examples of these organisations include Centre for Policy Research, Parliamentary Research Service, Centre for Civil Society, Vidhi Centre for Legal Research, Indira Gandhi Institute for Development Research and NIPFP. An array of independent writing now dissects laws and regulations, and creates resistance against badly drafted laws. This is an important and welcome new phase in the policy process in India -- in the maturation of the Republic -- one we think should be received with enthusiasm by the new government.

4 task forces setup by MOF to build institutional capabilities for FSLRC

FSLRC's institutional architecture

The draft Indian Financial Code (IFC) envisages seven financial agencies outside the Ministry of Finance:

1. Financial Sector Appellate Tribunal (FSAT): An improved version of the existing Securities Appellate Tribunal which will hear appeals all across the financial system.
2. Public Debt Management Agency (PDMA): The investment banker for the government.
3. Financial Redress Agency (FRA): The one-stop shop where any individual goes to raise a complaint about a financial service provider, where the difficulty was first raised with the financial service provider but not satisfactorily resolved according to the consumer.
4. Resolution Corporation (RC): A specialised organisation that will handle distress in certain kinds of financial firms.
5. Financial Stability and Development Council (FSDC): Systemic risk, coordination, development. This contains a database named Financial Database Management Centre (FDMC), which is the one-stop shop where all financial service providers electronically submit all the data that they have to give to financial agencies.
6. Unified Financial Authority (UFA): Consumer protection and micro-prudential regulation for all finance other than banking and payments.
7. Reserve Bank of India (RBI): Monetary policy, and consumer protection and micro-prudential regulation for banking and payments.

Shifting to this financial regulatory architecture will (a) Close the gaps, of the things that are at present not being done; (b) Improve economies of scale and economies of scope for the economy and for these agencies, and (c) Sharpen accountability by clarifying objectives. This reorganisation addresses the problems that derive from the arbitrary choices embedded in the system that we have inherited.

It is one thing to design a clean financial regulatory architecture. The next challenge lies in implementing it. Let's think through what's required for all the 7+1 agencies.

1. FSAT builds on the best tribunal in India today, SAT, and will become a high quality court.  It has to plan for the much higher case load that will come to FSAT under the IFC when compared with the present arrangements with SAT.
2. PDMA is a capability which is absent today. Subsets of the work that PDMA has to do are to be found within RBI and MOF but the full task is not being performed in India today.
3. FRA: at present, there are multiple ombudsman systems running in RBI, SEBI, IRDA, etc. FRA brings these together under one roof, with a high quality IT system.
4. RC: Is a new capability which does not exist in India today.
5. FSDC: Is an enlargement of the existing FSDC, which gets shifted out of the Ministry of Finance. FDMC has to be built.
6. UFA: In terms of the areas covered, it is a merger of SEBI, PFRDA, IRDA, FMC and some things which are presently in RBI. In terms of the work being done, it is different from what these agencies do today.
7. RBI: In terms of the areas covered, banking and payments and monetary policy are in RBI, but these things are done in different ways under the IFC.
8. MoF: The IFC has important implications for MoF which has to think and work in new ways. Many people have not noticed the big changes that flow from the IFC for MoF.

The key bottleneck in India: State capacity

Once Parliament enacts a law, this has to be enforced, either by an agency (e.g. RC) or by the main line structures of government qua government (e.g. MoF).  We in India have a long history of under-performance in the enforcement of laws.

This is partly grounded in badly drafted laws, which lack accountability mechanisms, lack clarity of purpose (which reduces accountability) and embed extreme executive power and discretion (which reduces accountability). The underperformance of RBI or SEBI is partly the consequence of drafting problems of the RBI Act and the SEBI Act.

But the underperformance is also grounded in bad public administration. A lot of new work is required in public administration, so as to obtain good quality execution. Alongside bad laws, bad execution is an equally important source of underperformance. This takes us to questions like organisation diagrams, HR policy, process manuals, reporting, internal IT systems, etc.

In developed countries, there is rapid execution in the implementation of new laws. E.g. the UK was extremely impressive in their translation of their new law for resolution of financial firms into State capacity for enforcement. In India, the experience has been that it takes a long time to implement, and particularly to implement well.

It will take some time for the IFC to get enacted. Recognising the bottlenecks of State capacity, we should worry about the delays, and about the quality of the execution, in living by the IFC once it is enacted.

Building institutional machinery ahead of time

Reflecting these concerns, there is a long tradition in India, of building institutional capacity before a law is enacted. Here are a few examples:

• SEBI was created by executive order in 1988, and the law came in 1992.
• PFRDA and NPS were constructed 2003-2005, while the PFRDA Act was enacted in 2013. 
• NSE started building Nifty and the real-time risk management system for derivatives trading at NSCC in 1995, while cash settled derivatives only became enforceable in 1999.
• Work on building the depository began inside NSE in 1995, before the legal foundations for dematerialised settlement fell into place in 1996.
• Work on the IT systems for the Goods and Services Tax (GST) began at NSDL in 2011, and the GST has not yet been enacted.

These are just a few examples that I have been around; there are many other episodes of this nature. The general principle is: Once the direction of future legislation is clear, project planning for enforcement of the law commences. Hence, once the budget speech of 2014 has established the legislative direction on the IFC, we should now build the institutional machinery through which the IFC would be enforced.

The MOF announcement today

Today, the Ministry of Finance has announced `Task forces' to build four components of the institutional machinery of the IFC. They are:

1. Financial Sector Appellate Tribunal (FSAT). Chairman: N. K. Sodhi.
2. Public Debt Management Authority (PDMA). Chairman: Dhirendra Swarup.
3. Resolution Corporation (RC). Chairman: M. Damodaran.
4. Financial Data Management Centre (FDMC). Chairman: Subir Gokarn.

The press releases are : overall, FSAT, PDMA, RC, FDMC.

The task forces are implementation teams which start from the design which is in the text of the IFC, and build the institutions that will implement the IFC. The output of the task forces will be working institutions. Other than the RC, the remaining projects are primarily about building complex IT systems.

With these four in motion, there is only one completely new component of the FSLRC institutional architecture where there is no progress, the Financial Redress Agency (FRA).

Twiddle your thumbs?

SEBI had to twiddle its thumbs from 1988 to 1992 as they had no powers in the absence of the law. NSE built the institutional capability to trade equity derivatives by 1998 and had to twiddle its thumbs till the politics worked out. All situations where institutional infrastructure comes up ahead of time have that tension within, of a race between the legislative process and the State capacity building project. The work of the four task forces that have begun has an array of possibilities, ranging from immediate impact to twiddle-your-thumbs:

1. FSAT: If SAT voluntarily chose to use the new institutional capabilities built for the FSAT, then those could be valuable right away.
2. PDMA: The new muscles of the PDMA could be of limited use to the Ministry of Finance in some ways that are compatible with the existing law.
3. RC: The Resolution Corporation must twiddle its thumbs until the IFC is enacted.
4. FDMC: Some or all of existing financial agencies could choose to voluntarily utilise the services of the FDMC, which will be a better IT-driven mechanism for submission of data from financial service providers to financial agencies.

The new work on building State capacity could thus start giving gains for the economy even before the IFC is enacted.

How we got here, and where we go next

The first phase of Indian financial reform ran from the reform of the equity market (1992-2001) and till the setting up of the NPS (2003-2005). Important new institutional infrastructure was created in this period: SEBI, NSE, NSDL, CCIL, IRDA, PFRDA, the NPS. The key features of this first phase were: (a) Responding to immediate difficulties and (b) Thinking one sub-sector at a time. Some parts of Indian finance made enormous progress in this period, such as the equity market and the pension system.

A long period of stagnation followed. This thought process shifted up from one sector at a time to thinking on a financial system scale, looking at the requirements of the economy even without the immediate impetus of a scandal. This started with the Percy Mistry report of 2007, and led up to the IFC in 2013. The IFC is now the centre of Indian financial reform, and is coming about on three tracks: the legislation, the Handbook, and these four task forces.

In many ways, these four projects are more complex than the new institutions of 1992-2005. The institution-building experiences of that period have many lessons, which have been incorporated into the construction and work procedure of the four task forces. E.g. the non-statutory SEBI drafted the SEBI Act, but now we understand that the Agent should not have a say in the contract between Principal and Agent. Similarly, the clarity of the four TORs of the task forces is not to be found in comparable documents from the 1992-2005 period. Institution building that period relied a lot on Level 3 thinking ("the great man theory"), whereas now there is an accent on formal processes that yield predictable outcomes.

All this connects with the core question of bandwidth and State capacity. In the past, one crack team at a time would setup one new institution.  There are concerns about whether there is State capacity to implement the IFC, and there is reason to believe that State capacity in financial economic policy has improved substantially when compared with what was available 1992-2005. At the same time, the four task forces are a daunting challenge: doing four new institutions at the same time has never been done before.

Hierarchy of thinking about politics and the state

Level 0: Indifference

"Politics: What's that? Gimme my beer."

Level 1: Naivete

"For every problem there is an equal and opposite NGO"

or

"Let's pick monetary policy by referendum"

or

"My favourite government program is the answer".

Level 2: Cynicism

"Politics is hopeless. Gimme my beer."

Level 3: The Great Man Theory

"If only Baba Hazare were the Commissioner of Police, torture by the police would come to an end".

Level 4: Small steps

"Civil servants should come to work on time"

Level 5: Fundamental reform

"Rewrite laws, redesign organisations, establish accountability".

"Don't clean the streets. Fix the institutions that clean the streets".

User rights as a novel instrument for infrastructure financing

by S. Ramann and Manish Kumar Singh.

An issue on the front burner for the Government today is how to raise financing for the trillion dollars of infrastructure investment required in India. The banking system is facing significant stress, and cannot finance the second wave of investment in infrastructure as it did with the first wave from 2002 to 2012. In this discourse, so far, the main strategy that has been emphasised is the development of the corporate bond market, which includes setting up trading infrastructure, removing capital controls, removing taxation of non-residents, removing barriers against currency derivatives, etc.

We would like to propose one additional element that could help infrastructure financing. We go back to infrastructure financing in the US in late 19th century, where future consumers of train trips became investors in railroad projects. This was done using a form of adebt instrument called User Rights (UR). In a recent paper, User right as a mezzanine capital investment: Innovations in infrastructure debt financing, we analyse this approach to infrastructure financing. In modern terminology, this is crowd-funding for infrastructure from potential consumers. The key insight is to harness users as financiers with a high yield, tradable debt instrument. For a price paid at the time of financing the project, the UR entitles the holder to a rebate on user charges for that project.

As one example, in the paper we analyse a UR that offers a 45\% rebate on fares for one-way journeys on Mumbai Metro Phase I, Line I, for a period of 30 years from the commencement of its operation.

Benefits to UR holders

The UR gives the holder the right to receive a fixed rebate for a fixed period of time when using a well-identified infrastructure facility. What is the fair value of such a right? The price is calculated as the Net Present Value (NPV) of the future stream of rebates. The discount factor would include a risk tolerance parameter based on the probability that the facility will become operational and on the probability distribution of the future price of the facility.

We calculate that it is possible to design a Mumbai Metro UR, priced at Rs.13,978, which gives a saving for the user that starts at Rs.1,381 in the first year, and steadily increases up to Rs.2,825 in the final year. The implied rate of return works out to 10.5 percent, which is higher than the return from investment in tax free PSU bonds at 8.7 percent. The tax free status is not mandated by the government: since no interest is paid to UR holders, there is no tax. The gain is solely from savings on ticket cost.

Since the UR holder is entitled to a rebate, the UR becomes like an insurance contract for the UR holder compared to non-UR holders who use the operational facility. In the paper, we demonstrate other situtations under which the URs can be used strategically to better manage the risk of future increases in the ticket price. The more the final price varies from the scheduled increase in ticket price, the larger is the benefit received by the holder of user rights.

Benefits to issuers

We use a simulation to estimate savings to the project by financing using URs. The simulation is calibrated using the financial information of other metro projects in India. The simulation shows that when the project collects money against sale of user rights at the start of the construction period, the saving in interest payments is high enough to improve project viability. In the Reliance Metro example, substituting a part of debt (which is loans at 11.25 percent) by the issue of user rights, improves the NPV by about 9 percent. The cost of servicing user rights is postponed to the revenue generating phase thereby reducing the required working capital.

Wider economic benefits of URs

Infrastructure financing through URs also has many other economic advantages:

• Higher standardisation and simplicity - Unlike loans and bonds, URs are standardised and comprehensible, and lend themselves to be traded at exchanges. Easy entry and exit can facilitate wider investor interest, leading to a more heterogeneous participant base which can likely lead to more liquid markets compared to traditional bondsinstruments.

• Better accountability - As UR-holders, consumers would have higher incentives to monitor infrastructure projects compared to traditional financial intermediaries. Consumers interests are better aligned with better monitoring of the project, which could impose better project governance, compared with banks and asset management companies who suffer from agency problems. Further, users as financiers to infrastructure projects may inject direct pressure on elected governments, and hold them to a higher standard of accountability on such projects.

• Scalability across projects -- The UR as a financing instrument can span across any infrastructure project -- by the government, under a public-private partnership or even as a purely private initiative -- that produces a service that could be consumed by individuals. Examples include hospital services, community solar power plant or water and sewerage services. The degrees of assurance to the investing public may vary with the type of operator and arguably the degree of confidence in the operator.

• Augment existing credit sources -- The government is hard pressed to turn to traditional sources of infrastructure financing in India. Commercial banks face high asset-liability mismatch from financing long term infrastructure projects. Bond-based financing is constrained by the lack of resolution when projects fail. Structural constraints of infrastructure projects lead to low ratings by credit rating agencies. This, in turn, poses a barrier for these new projects accessing debt financing from institutions with long term liabilities such as insurance and pension funds. Foreign currency denominated borrowing imposes forces additional mismatch of currency risk. URs avoid all these problems and could hence become one interesting component of infrastructure financing for some projects.

Challenges and Concerns

URs are of course not the panacea for all ills associated with infrastructure financing. Large initial investments, long gestation periods, unanticipated construction delays leading to incorrect projections, collection risk of payables and reneging of contracts are major risks in infrastructure projects. These factors also lead to higher uncertainty in assessing the discount rate used in the NPV calculation to price these instruments, and can lead to high price volatility. The advantage that URs have over the traditional credit instruments are that the risks are spread over a much larger audience, and that re-pricing of risk is transparent.

A key concern would be on protecting the rights of the UR holders if the project were to fail, and the facility failed to materialise. One approach could be to invoke an insurance mechanism or debt reserve ratio to repay the principal amount of the investors. Such a mechanism would not come for free and would be incorporated into the cost of the project, which in turn would be borne by the URs holders. This might have marginal price impact if such costs are priced across millions of URs issued. Another alternative that we may visualise is for agencies such IIFCL or LIC to provide a guarantee as part of the UR. This could be financed from an independent source.

Conclusion

In a country that faces multiple challenges in raising capital to support an escalating infrastructure financing requirement, URs can be a useful and innovative debt instrument to tap new funds. URs raise capital based on legitimate expectations of urban residents for consuming infrastructure services. More importantly, it empowers the consumer as a stakeholder which could lead to better governance of long term public goods projects compared to the traditional financial intermediaries as their agents.

RBI vs. Uber, continued

by Suyash Rai and Ajay Shah.

On 22 August 2014, RBI came out with an order which effectively forces firms such as Uber to either shut down, or switch to cumbersome payments mechanisms.

On 24 August, we wrote an article Shutting down Uber in India was unwise about the economic thinking in payments regulation.

On 15 September, Raghuram Rajan responded to this criticism in a talk, saying:

If there is a rule on the book, we don't allow it to be violated simply because the innovation is cool.

We think that RBI's action does not even constitute proper enforcement of `a rule on the book'. We think that regulators like RBI cannot pass the buck for bad consequences of rules that are fully under their control. We think that if RBI was wise and accountable, it would have behaved differently. Let's work through the steps of this logic.

Does the RBI action constitute sound enforcement of existing law?

Let us first examine what Rajan claims RBI has done - enforcement of current laws and regulations. The RBI's notification states that the routing of payments through offshore payment systems was violating the Payment and Settlement Systems Act, 2007 and the Foreign Exchange Management Act, 1999, and must be immediately stopped. It then allows the firms to make the necessary changes by October 31, 2014. This is unsound enforcement, for the following reasons:

• The notification just states that the activity is in violation of two Acts, without actually citing the specific provisions or regulations of the Acts, and providing grounds for determining that the activity is violating these laws. For an analogy, this notification is like the police arresting a person saying that he has violated the Indian Penal Code, without citing the specific sections and without providing the reasons for such an assessment.
  
• Instead of taking proper enforcement action - starting with a show cause notice and perhaps ending with a penalty - the RBI has simply allowed the firms to "adjust" by the given date. Unlike what Rajan claims, this is not enforcement by any stretch of imagination. An enforcement action by a regulator has to first establish that the enforcement action is necessary, and in a case such as this (assuming the RBI is correct regarding Uber's activities), result in a punishment.
  
• The notification, which claims to be a clarification, is vague. It does not describe instances or specific actions that would be deemed to be in violation, so that market participants can understand where they stand. As a result, it has created significant confusion in the market.

RBI cannot be an impassive enforcer of rules that it has drafted

If you were the police, you merely enforce the Indian Penal Code (IPC). When a situation arises in front of you like marital rape, you have to be mindless and say, `Sorry, the IPC is clear that rape in marriage is not a crime, and my hands are tied'. The police does not make the law, it simply enforces it. If the police finds someone violating the IPC, it is its duty to take necessary actions as per the Law.

On the other hand, Rajan's stance - that clamping down on the routing of payment transactions is simply enforcement - is inappropriate. Unlike the police, RBI is not just an enforcement agency. RBI is a regulator. It writes the regulations that it enforces. The regulation for payment security was made by RBI, not Parliament, and therefore can be changed by RBI. Regulators exist because there is value in merging legislative, executive, and quasi-judicial powers within a single organisation.

Once RBI found that some real economy firms with efficient solutions are feeling compelled to find loopholes to give convenience to consumers on services such as taxi rides (which are usually small value transactions), this should have triggered a process of review of relevant regulation. Instead, Rajan simply brushed off the criticism of RBI on this matter, claiming that the critics are calling for suspending enforcement for a "cool" innovation. The critics are calling for no such thing.

Regulations must be enforced, otherwise they are meaningless, but if the regulations are wrong, they must also be reviewed and optimised. What Rajan is dismissing as "cool" is a small but non-trivial improvement in convenience (and productivity) that many consumers were choosing before RBI stepped in. India's future relies on the ability of innovators to come up with myriad small process improvements like this one. So, in addition to enforcing the regulation, it would have been wise of RBI to rectify the problems in regulation that compelled firms to take such a strange and risky route to receive payments.

There are at least four major problems with the regulation that RBI has drafted on two-factor authentication:

1. It lacks proportionality: it requires the same level of protection for small value transactions as it does for large value ones.
2. It unreasonably restricts economic freedom of consumers: we do not even have the right to waive the requirement for second factor authentication for small value payments (eg. up to Rs. 1000) on own money, even if we are willing to take that risk.
3. It focuses too much on prevention and not on enforcement: the approach is to eliminate the possibility of fraud by imposing costs on consumers. You face no risk of a motor accident if you live in the stone age.
4. It takes initiative away from payment service providers: service providers are supposed to blindly follow RBI's dictum. They do not have the right to relax authentication requirements for some transactions, with the understanding that they would manage risks and make good on losses that occur due to their mistakes.

To ignore these problems, to insist on enforcing a badly drafted regulation, no matter what the consequences are for the economy: this is the hallmark of an unaccountable agency.

If RBI were wise and accountable, what would they have done?

Once RBI noted the route firms were using to get around the two-factor requirement, and that many consumers were willingly using the service with lesser security (signalling a preference for convenience over security for small value transactions), it should have embarked on a comprehensive review. While initiating proper enforcement action against firms allegedly violating the laws, on 22 August 2014, RBI should have issued a statement (perhaps through a press release) saying the following:

1. "We have a legal framework comprising FEMA about cross-border activities, and two-factor authentication about payments.
2. "Some companies, such as Uber, are in a grey zone when it comes to FEMA. They are using this mechanism to avoid our rule that requires two-factor authentication.
3. "We recognise that these are important mechanisms through which the market economy, comprising of service providers and consumers, is choosing to operate. The emergence of these mechanisms raises questions about the soundness of our two-factor authentication rules.
4. "The tradeoff between security and convenience, and between prevention and enforcement, embedded in our authentication rules is questionable. We need new regulations, which impose some burden of liability upon financial service providers, and empower consumers to make a choice to waive second factor requirement on small value transactions. The default condition may continue to be two factor authentication, unless a consumer opts out for small value transactions, or a service provider takes it upon itself to manage the risk and take liability for failures.
5. "It is important for regulators to not disrupt organisational capital of firms. Hence, the loopholes which are presently being used will be closed down on October 1 and the new rules will simultaneously kick in. Through this, it would be possible for firms such as Uber to experience no breakdown of operations.
6. "Enforcement actions will proceed against violators of FEMA who may have to pay fines for the offences. This process will begin with a show cause notice, and may end with a penalty order by an adjudicating officer, if sufficient evidence is found on violation."

This would have been a wise and mature approach to financial regulation, one that fully takes into account the mandate of an accountable financial regulator and its responsibilities to the economy.

Rajan's defense of the current system is that two-factor authentication has enhanced peace of mind for people, who were earlier at risk of losing money. But nobody is suggesting unconditionally removing all authentication requirements or consumer protection provisions. The choice should not be posed as existing RBI regulation vs. zero regulation. Instead, the argument is for applying proportionality in security, giving consumers the freedom to waive the second factor for small value transactions, and holding service providers liable for risks they agree to manage.

Overall, the criticism has far more nuance than Rajan has acknowledged.

He also says, as people too often do in India, that innovations from the West do not directly apply in India. This is a particularly harmful argument, because it works as a broad excuse for prohibiting or delaying all kinds of innovations. Rajan should be more precise about what safeguards are required for specific risks that accompany the innovation being discussed, and what his agency will do to address them efficiently. This precision is required, not vague pronouncements on the harm from importing innovations.

Rajan did say that RBI is considering some changes to the system, but it is not clear what these changes will be and when are they likely to be implemented. Till the time he decides to give greater clarity on the issue, affected parties must wait. This sort of waiting, and legal uncertainty surrounding new thinking about business models, is incompatible with high GDP growth. In this process, we have lost sight of the purpose for which a regulatory agency is established, and that it exists for the purpose of serving the people of India.

This is just the tip of the iceberg

Millions of people understand in their bones that forcing a firm like Uber to shut down is a bad idea. In this one case, we have got a careful discussion about RBI regulation in public domain. The real issue runs deeper : an unaccountable agency has written myriad unwise regulations, that are holding India back. Greater humility, and an interest in reform, is the need of the hour.

RBI's `wilful default' framework vs. the rule of law

I have an article in the Indian Express today titled RBI's `wilful default' framework vs. the rule of law.

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.