China watchers now recommend watching and other links

Visited John Pomfret twitter handle after a long time. Good harvest. Some of the harvest shared here:

China watchers recommend vigilance now. WaPo story; summary of the report here and the full original report is here.

Cornell halts China university ties over curbs on academic freedom [Link]. An important observation in the story:

Chinese regulators closed down more than a fifth of partnerships between local and foreign universities this year.

The tweet says it all:

China is loosening environmental regulations facing a weaker economy. The new policy allows a much higher PM2.5 level in northern China than announced a year ago, and heavy-polluting factories can operate again in the winter. [Link]

China shutters one of its truly independent think-tanks [Link]

A dispassionate look at RBI revaluation reserves and other demands of GoI

On November 19, the Board of Directors of the Reserve Bank of India met and agreed to constitute an expert committee to determine the appropriate level of economic capital that the central bank must hold. So, now, all of us have the time to evaluate the issue more objectively.

Niranjan Rajadhyaksha (former Senior Editor at MINT and a good friend) wrote a column in MINT which basically gave the following message:

  1. The equity plus contingency reserves have hardly increased
  2. Revaluation reserves have reflected growing FX holdings
  3. Comparisons with other countries is really not useful unless we understand the specific institutional arrangements.
  4. The government has really not given us a solid argument other than RBI has more capital as a proportion of BS than other CBs.

Few days later, just on the day of the RBI Board Meeting, MINT published an excellent interview with economist Indira Rajaraman. 

She said the following:

I think in a lot of what RBI does, there is this sense—I am not attributing it to the present governor—an institutional sense that there are things that have to be done in public interest which the public cannot quite comprehend. That has to go. I think there has to be a sense that the public can understand if they are made to understand.

The questions that North Block is raising exhibit a fairly nuanced understanding of a number of issues. Let’s say the 12 issues that were raised by the government in the three letters to RBI. I was quite surprised at the depth of understanding in North Block of the various issues and in particular on the reserves issue. I think it was time the question was asked and RBI was made to defend its particular level of reserves.

Mr. Malegam, who is considered a high priest on the reserves issue as he has been on the board for so many years and has chaired a couple of committees on it, has said that under Article 58 of the RBI Act, there is no provision for transfer of reserves to the government. I do not agree with him there.

Yes; of course, in Article 58, there is no explicit provision for transfer of reserves, but then again, there is no provision that reserves must not be transferred. There are a lot of things unsaid in the legislation and for the government to have identified that hole and to say that there is possibility of transfer and tell us why you cannot transfer. 

In addition, there have been many regulatory lapses during the last year which have led to a sense among the ministry of finance and educated watchers that the regulatory plumbing needs to be overhauled.

For instance, the RBI annual report is a submission of the board of RBI to the ministry of finance and not of the RBI management to the ministry of finance as was the general impression.

The annual report used to be placed in the draft form for a 15-minute examination by the board before it was pulled away for finalization. I used to speak up and tell my board members that this is going from us and we should read this. In the four years, I was probably the only one who insisted on a draft and having a video link with RBI in Mumbai with my comments on every page of the draft.

I am sure I was considered a nuisance but I took my responsibilities seriously as a board member of RBI and wanted that the annual report should be accurate portrayal of RBI’s functioning.

The board for a long time was not aware of its powers. In a certain sense, this confrontation has brought to the fore the role of the board, its powers and responsibilities and made the management more aware that they are accountable.

RBI has to engage as its actions impinge on everyone in the country. There has to be more transparency and more willingness to talk to people who do not understand the intricacies but are still in need of an explanation.

I don’t think they are just motivated by the fiscal concern. There is the liquidity concern also which could be termed as in the public interest.

The important thing is that RBI has to look into each issue on its merit.

For instance, on the liquidity issue, the government asking for a calculation of the liquidity squeeze, or asking why does the central bank think that liquidity is adequate; I think the ministry of finance is perfectly justified in it. [Link]

Given her intellectual depth and breadth of experience, her own previous association with RBI and her final wish for this institution to be nourished and cherished lend her criticism of RBI a far greater authenticity and credibility than that of the many unthinking, reflexive defences of RBI.

Revaluation Reserves:

Revaluation Reserves are gains accruing from the rise in the value of the foreign currencies and gold agaisnt the Indian rupee. That is why it has swelled to about 25% of the Forex and Gold Reserves.

In general, for India, the revaluation reserve will only keep rising. The rupee has a history of depreciation and for the right reasons. India is productivity and scale challenged. Hence, it is export-challenged and hence, it is current-account challenged.

Therefore, the risk that a sharp appreciation of the rupee will erode the value of the foreign currency assets that RBI holds and hence, it should be adjusted against the revaluation reserves is rather remote for the foreseeable future.

Revaluation reserves have reflected growing FX holdings – that is factually correct. Revaluation profits will keep occurring with a currency that is a ‘depreciating unit by default’. India’s revaluation reserves at about 26% of RBI’s Foreign Currency and Gold Reserves is too high.

Bank of Brazil’s revaluation reserves are a very tiny portion of its foreign exchange reserves. Indeed, Bank of Brazil’s overall equity (capital + reserves) is rather modest. [Link]

In contrast, Bank of Russia’s capital is nearly 37% of its balance sheet size! Bank of Russia does not give breakdown of its capital into capital and reserves.

People’s Bank of China Balance sheet for 2017 shows that the bank has far too tiny a capital base and no revaluation reserves.  The Chinese yuan does appreciate more often and in greater magnitude than the Indian rupee does. It has a huge cache of foreign exchange reserves which loses value whenever the yuan appreciates. Yet, they do not have revaluation reserves. See here.

So, the question arises as to why India has such a large revaluation reserve of around 26.2% of its total foreign assets (INR6916.41 billion against total foreign securities of INR7983.89 billion + INR18366.85 billion as of June 30, 2018). On top of this, there is a contingency reserve of INR2321.08 billion. [Link]

There is an interesting article in ‘India Express’ (ht Usha Thorat, former RBI Deputy Governor) published on November 19, 2018, written by P. Vaidyanatha Iyer:

In June 1994, while finalising its balance sheet, the RBI realised it was unable to provide for the exchange loss liability on account of a foreign currency deposit scheme offered by banks since 1975. …

The scheme was called the Foreign Currency Non-Repatriable Deposit Scheme, or FCNR-A, and was introduced to attract capital inflows and help finance deficit in the current account. Prodded by the government, banks offered interest rates higher than what they offered on local deposits. These deposits ballooned in the 1980s.

The RBI had agreed to provide exchange guarantee on these deposits. It didn’t think too much into the future then, and had a simple rationale: the dollars were added to foreign currency assets, these were revalued when the rupee depreciated, and so the revaluation gains would be available for meeting losses during repayment of principal. The interest to be paid on the FCNR-A deposits would be met through earnings on the dollars invested abroad.

But then, India was hit by a Balance of Payments crisis in the late 1980s. According to sources familiar with the developments then, the forex assets depleted fast and even the $1.1 billion of assets in 1991 represented dollars sold forward under a separate swap arrangement with State Bank of India. The losses from 1991 till 1994 were met by drawing from the Exchange Equalisation Account and the Contingency Reserve of the RBI. By 1994, both these reserves were fully depleted, and there was no source for providing for exchange losses on $10-billion worth dollar liabilities under the FCNR-A scheme.

The FCNR-A liabilities comprised $5 billion in principal and $5 billion in accrued interest. The average rate at which these dollars were bought was about Rs 16 a dollar. In 1994, the exchange rate was almost double at Rs 31.37, meaning the RBI had to bear a loss of Rs 15 more on every dollar. The total loss added up to Rs 1,500 crore. [Link]

Now, we understand the situations for which the revaluation reserves and contingency reserves were put to use, earlier.  But, since then, RBI does not offer exchange rate guarantees. Commercial banks bear the risk when they attract dollar deposits.

The ‘Usha Thorat Committee’ had recommended a total of 18% of assets for both revaluation reserves and contingency reserves. Actually, the denominators are slightly different. The ‘Currency and Gold Revaluation Reserve Account’ of 12-13% is calculated against foreign curency assets and gold holdings whereas the Contingency Reserve of 5% is on overall assets. Foreign currency assets constituted roughly 73% of total RBI assets as of June 30, 2018.

I understand from reliable sources that contingency reserves are held by the Reserve Bank of India for the following reasons:

  • when market intervention operations cost more than the anticipated;
  • for shortage in deposit insurance fund;
  • for any cyber security risk;
  • for ‘lender of last resort’ function and
  • if there is no transfer to GoI because of above contingencies, then it could affect fiscal math -hence some minimum profit transfer to GoI had to be assumed by RBI each year for better fiscal management by the Government

The Economic Survey of 2015-16 had recommended that total reserves be 16% of RBI assets, reduced from 32% (Box 1.6, Chapter 1, p. 19, Economic Survey 2015-16) and wanted the ‘excess reserve’ be used for bank recapitalisation. [Link]

So, even if the government fiscal math was behind the recent clamour for RBI’s ‘excess’ reserves, it is not unreasonable because the fiscal math was not undone by any reckless spending on the part of the government but because of the introduction of Goods and Services Tax, because of the failure of investment cycle to kick in, leading to higher economic activity and tax revenues, etc. Further, although bank recapitalisation charges were not reckoned with for fiscal deficit calculations, interest paid on the amounts would be added to the government expenditure.

Indian newspapers today have flagged a recent Bank of America – Merrill Lynch report which mention the excess reserves that RBI could potentially transfer to the Government of India. The report puts the figure between 1,00,000 crores of rupees and 3,00,000 crores of rupees (INR 1.0 trillion to INR3.0 trillion). See here.

So, there is a case for cooler heads and some transfer of excess reserves from the Reserve Bank of India to the Government of India.

How does RBI pay this to GoI?

My proposal is this:

Let a certain portion of the Revaluation Reserves be written back to the Income Statement every year, over 3 to 5 years. Then, it can be paid along with the profits for the year to GoI. To be sure, during this period, the revaluation reserves may increase if the rupee depreciates. Then, the duration may get lengthened. So, be it. Amortizing the payment to GoI over a period is the least-disruptive way to reduce the Revaluation Reserves from its current ‘excessive’ level to a comfortable level and also avoid the accusation that it is a short-term expedient for the present Government.

What about the other demands of the Government of India?

Ananth Narayan has neatly listed the government demands in his latest article in ‘Economic Times’:

  • The government wants the RBI to relax lending restrictions on the notionally weak banks that are under RBI’s Prompt Corrective Action (PCA) framework.
  • It wants RBI to provide forbearance (in other words, to close its eyes) on stressed loans, particularly to the power and micro, small and medium enterprise (MSME) sectors.
  • It wants to access the capital on RBI’s balance sheet.
  • Finally, it wants the RBI to provide relief to stressed non-banking financial institutions (NBFIs).  [Link]

We have dealt with no. 3 in the list in this blog post.

On the other three demands, my suggestion is that the Government should bite its lips and not interfere with the central bank’s current stances. After all, they are the extension of the structural reforms that the Government itself had undertaken – willingly or otherwise.

It did demonetisation; it introduced the Goods and Services Tax; it enacted the Insolvency and Bankruptcy code and it passed the Real Estate Regulation Act. All these mean discontinuity with the status quo that had prevailed for the previous sixty-seven years. Similarly, regulatory forbearance has been the practice of the previous sixty-seven years. In these areas, RBI is wanting to signal a change. It is welcome. It is painful in the short-term. The government has to bite its lips and face the short-term growth disruption and the complaints of its core constituencies who might be affected.

To offset the political damage, the government must take the case to the people, as it did in the case of demonetisation. It must market itself as the champion of long-term structural reforms for the good of the nation, sacrificing its own personal and political interests in the short-term for the good of the nation.

Not easy but do-able. 

What should RBI do on its part?

It must come off its high horse and admit to failings in its regulatory architecture and practice. It should listen to Indira Rajaraman. As Dr. Y.V. Reddy said in a speech in February, it must come out with a white paper on non-performing assets, detailing its own failings. It must accept to regulatory shortcomings with respect to detecting frauds such as the one that happened in Punjab National Bank. The case of IL&FS highlighted failures in the regulation of non-banking finance corporations. It must be candid; admit to its inadequacies and failures, resolve to address them and outline steps it will be taking to do so, with clear timelines. It must report to the public on the progress of the redressal measures and close them within a reasonabel time-frame. 

As importantly, it must use the opportunity to address consumer issues as highlighted by Debashis Basu in this article in ‘Business Standard’ recently.

Of golden ages and worst economic managements

On Nov. 19, the RBI Board met. RBI put out a press release. A committee is to be formed to evaluate the adequate level of revaluation and contingency reserves that RBI could hold. It is now possible to analyse the issues dispassinately. Which means we don’t write stuff like this:

Will it now reverse the equally long trend towards genuine RBI independence? If so, this government will cement its reputation as providing the worst economic management India has had for decades. [Link] – ht Chris Wood of CLSA

The author of those sentences – Mihir Sharma – is also famous for lamenting that a golden age had ended when the UPA government demitted office in 2014. See here.

Obviously, his economics education has given him different benchmarks to rate economic performance. Sustained double-digit inflation for five to six years, rising fiscal and current account deficits, tumbling currency, retrospective tax amendments, quiet to blatant interference with the central bank and taxing start-ups’ share premium as income, falling capital investment rates, rising (eventually gigantic) non-performing assets in the banking system, corrupt allocation of natural resources that had to be cancelled and many more constitute golden era of economic management!

Low inflation, low current account deficit, steady economic growth, transparent auctioning of natural resources, pick-up in public investment, rising share of direct taxes in overall tax take, rising tax buoyancy, a successful financial inclusion initiative (PMJDY), scheme to restructure losses of the state electricity boards and for the States to reckon the explicit fiscal costs of their electricity subsidy, introduction of the nation-wide Goods and Services Tax, introduction of the Insolvency and Bankruptcy Code, introduction of the Real Estate Regulation Act, explict push to have big corporations pay their dues to supplies from small and medium enterprises, labour law reforms in BJP-ruled States, improvement in ‘Ease of Doing Business’ by focusing on key bottlenecks constitute worst economic management!

He writes that this government failed to take advantage of lower oil prices. He is right. It did not, because it had to use the oil price crash bonanza to fix the true federal government fiscal deficit of upwards of 6.0% of GDP that the UPA government had bequeathed. The mid-year economic report of the Department of Economic Affairs published in December 2014 has a special box on the pro-cyclical fiscal consolidation that the then recently installed NDA government had to do.

So, it is true that it did not take advantage of the oil price crash and pass on the bonanza to the economy. It chose to put the fiscal house in order and its mistake was in not publishing a white paper on the economy it inherited from its predecessor.

I am sure Indians are smarter to choose more wisely than him.

Ease of doing business in India – progress and pending problems

On Nov. 19, the RBI Board met. RBI put out a press release. A committee is to be formed to evaluate the adequate level of revaluation and contingency reserves that RBI could hold. The RBI-Government spat has moved off the headlines. India’s improved ranking in the ‘Ease of Doing Business’ dominated the headline.

Some found that the Government ‘gamed’ the ranking. It is a case of ‘lose-lose’ for the government with these critics. If India had slipped in the rankings, it would be pilloried. Since the ranking went up dramatically, these worthies found that the Government of India was capable of even gaming the World Bank rankings!

If only the GoI could game the rankings, it has some explanation to do as to why it could not improve India’s ranking in the ‘Ease of Starting a Business’ from the current level of 137.

In terms of ‘Paying Taxes’ one of the parameters in the ‘Ease of Doing Business’ rankings, India was ranked 121 in the ‘Doing Business 2019’ rankings. [Link].

In the ‘Doing Business Ranking 2018’, on ‘Paying Taxes’ parameter, India’s rank was 119. [Link – p. 167 of the report or p.174 of the PDF document]. 

India’s ‘Distance to the frontier’ in ‘Paying Taxes’ had shrunk. In other words, India has improved marginally on this parameter. India has improved to 65.36 from 65.23, the year before.

It is interesting to note that the ‘Distance to Frontier’ score was originally 66.06 for India on ‘Paying Taxes’ in the ‘Doing Business 2018’ report. It had since beeen revised to 65.23 and hence, 65.36 appears like a marginal improvement.

Also, the number of hours spent in paying taxes was estimated at 214 in the DB 2018 report.

But, after more data on GST payments had been obtained, this number was revised higher to 275 hours! [Link – see page 15]

This is what the PWC document had to say about the GST introduction process:

In 2017, multiple central and state indirect taxes were merged into one with the introduction of the GST system. The transition, however, led to some administrative, operational and system issues that increased the time to comply. For example, the rules for filing and paying GST and for determining the GST  rates were not always clearly communicated, there were issues with the functioning of the online portal and not all rules were synchronised prior to the introduction of the GST. [Link]

In DB 2019, the number of hours spent in paying taxes in Mumbai is estimated at 277.5 hours! [Link]. India is doing poorly compared to South Asia (slightly only since India is the larger share of South Asia); substantially poorly compared to OECD (159 hours) and Singapore (49 hours!). According to the PWC document linked above, the global average was 237 hours in 2018.

The total taxes and contribution rate (% of profit) was 52.2 (vs.55.3 in the previous year’s report). It is good that it is declining but still on the high side. OECD average is 39.8% and the best rate is 26.1%.

But, more than the tax rates, the number of hours spent in filing taxes and appealing assessments has a huge monetary component. The hassle of dealing with bureaucracy has a far higher monetary and morale cost than the actual tax paid.

Directing start-ups to calculate the ‘share premium’ received as taxable income, questioning companies as to why their valuation came down in subsequent rounds of investing are clearly not ways to boost entrepreneurial and economic activity in India. [Link]

There is also the recent tax demand raised on the banking system imputing value to the free services that banks provide customers as ‘lost income’ for banks and hence ‘lost tax revenue’ for the Income Tax Department. It is, at once, a farce, a tragedy and surreal.

Banks are encouraged to concentrate on financial inclusion. Further, government wants people to transact through banking channels so that transactions could be monitored and traced, if necessary. If the tax demand is met, banks will either withdraw these services or levy higher and hidden charges elsewhere. Either way, some fraction of the public will disengage from banks.

Is this what one arm of the Government wants to do to Government’s policy objectives?

India’s ‘Ease of Doing Business’ rankings might have improved from 130 to 100 to 77. The improvement to 77 is supposedly based on the improvements effected in the areas of handling construction permits and foreign trade transactions. Well and good. They are necessary.

But, tax department figures in ordinary Indians’ lives – individual or commercial – on an almost daily basis. There, India has slipped and these reports tell us why.

This government has many structural reforms to its credit. Christopher Wood of CLSA in his weekly missive, ‘Greed & Fear’, has documented them well on 15th and 22nd November. But, tax reforms and tax administration are two very important structural reforms that are not only pending but have become bigger problems in the last four and half years.

Hope over logic

Just happened to come across this news-story in Bloomberg. According to stockbrokers and investment banks, emerging markets will have better times in 2019 than in 2018. Simple rule of thumb is that if forecast did not materialise, simply forward it to the following year!

Correction in American stocks has just begun. There will always be whiplash rallies as happened on Monday. Corporate credit and leveraged loans markets are dangerously unstable. The risks in these markets are yet to play out.

Political risk in emerging economies is not to be discounted. Almost all the major developing economies have fragile political stability now – Turkey, Brazil, South Africa, India and China – for different reasons.

In this milieu, it is hard to nod vigorously to this cheery prediction which is, of course, the default option for these institutions.

On the contrary, if they had turned negative, it would be rather necessary to seriously examine the possibility that these markets had bottomed out.

Preference or prediction?

Saurabh Mukherjea has written two thoughtful pieces. One is on the possible end of ‘Peak Finance’. I like it and I endorse it. But, I am not sure if, in my case, it is a matter of preference or prediction. I suspect that the same question could be asked of Saurabh Mukherjea too.

He is spot on with this post-mortem:

In September 1981, the US 10 year Government bond yield hit a post-World War II high of 15.4%. In September 2016, it touched an a 50-year low of 1.6%. This epic downward trend in the world’s risk free rate has defined most of our careers. Had it not been for this downward trend, it is doubtful whether Emerging Market equities or Private Equity or Real Estate for that matter would be as big an asset class today as it has become. In fact, in the broader scheme of things, the “financialisation” of the global economy which has taken place in our lifetime has been underpinned by this epic bull run US Government bonds. 

While this post-mortem is definitely a valid explanation, in my view, I am not quite sure – much as I wish – that the phenomenon is ending because a lot of forces want this to continue, including President Trump! Candidate Trump railed against it but President Trump is aghast that the Federal Reserve has taken him seriously!

Allied to this is another piece that he has written for Bloomberg Quint on the return of alpha in stock market investing. Again, I hope, he is right. Only when the tide runs out, we would know who was wearing swimming trunks or not. But, will the tide really run out or will central banks blink and keep the punchbowl topped up? I am not sure we have clarity that they are truly independent – of financial markets, even as they wag their fingers at politicians.

Is it really the spine issue?

A detailed examination (ht Aru Arumugam) of the independence (or, the lack thereof) of Directors on corporate boards in India. Worth a read.

The problem is that most independent directors view the directorship as a favour conferred on them by the management. Two, they really do not spend that much time on the inner workings of the company. It is almost impossible to detect frauds with the level of engagement they have. Three, if they have to do a thorough job of it, they need to be full-time, in which case the compensations they earn as independent Directors are simply too meagre to require extensive time commitment.  Four, therefore, the requirements of the law on independent Directors on the Boards of publictly listed companies are disproportionately too onerous.

So, what will happen is that honest, sincere and competent individuals will stay away, defeating the very purpose and intent of the laws. Talk of unintended consequences, yet again!