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GS Paper: Indian Economy

  • Need for a Bad Bank

    The idea of setting up a bad bank often comes up for debate, especially when stress in the banking sector is projected to rise in the near term.

    Practice question for mains:

    Q. What is a Bad Bank? Discuss how it can rescue the covid induced bad loans in India.

    COVID induced NPAs

    • Several economists and agencies project a recession in the Indian economy this year, due to the adverse effects of Covid-19 on economic activity.
    • This will hit the banking and financial sector in particular, as a slump in earnings of companies and individuals could lead to a jump in NPAs, reversing the early trends.
    • Various analysts suggest that in a couple of years, the proportion of stressed assets in the banking system could jump to as high as 18 per cent from around 11 per cent at present.
    • To tackle this upcoming challenge, the banking industry has proposed the setting up of a government-backed bad bank.

    What is the Bad Bank?

    • A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution.
    • The entity holding significant NPAs will sell these holdings to the bad bank at market price.
    • By transferring such assets to the bad bank, the original institution may clear its balance sheet—although it will still be forced to take write-downs.
    • A bad bank structure may also assume the risky assets of a group of financial institutions, instead of a single bank.

    What is the recent proposal of a bad bank?

    • The banking sector, led by the Indian Banks Association (IBA), had in May submitted a proposal for setting up a bad bank to the finance ministry and the RBI.
    • The IBA proposed for having equity contribution from the government and the banks.
    • This was based on an idea proposed by a panel on faster resolution of stressed assets in public sector banks headed by former PNB Chairman Sunil Mehta.
    • This panel had proposed an asset management company (AMC), ‘Sashakt India Asset Management’, for resolving large bad loans two years ago.
    • There were talks about creating a bad bank in 2018 too, but it never took shape.

    What kind of NPA spike is expected during this outbreak?

    • The impact of Covid-19 and the associated policy response is likely to result in an additional Rs 1,67,000 crore of debt from the top 500 debt-heavy private sector borrowers turning delinquent between FY21 and FY22.
    • Given that 11.57 per cent of the outstanding debt is already stressed, the proportion of stressed debt is likely to increase to 18.21 per cent of the outstanding quantum.

    What is the government’s view over Bad Banks?

    • While the finance ministry has not formally submitted its view on the proposal, senior officials have indicated that it is not keen to infuse equity capital into a bad bank.
    • The government’s view is that bad loan resolution should happen in a market-led way, as there are many asset reconstruction companies already operating in the private space.
    • The government has significantly capitalized state-owned banks in recent years and pursued consolidation in the PSU banking space.
    • In the last three financial years, the government has infused equity of Rs 2.65 lakh crore into state-owned banks.
    • These steps, along with insolvency resolution under the IBC, are seen as adequate to tackle the challenge of bad loans.

    What is the RBI view?

    • The RBI has so far never come out favourably about the creation of a bad bank with other commercial banks as main promoters.
    • Former RBI Governor Raghuram Rajan had opposed the idea of setting up a bad bank with a majority stake by banks, arguing it would solve nothing.
    • Rajan argued that a government-funded bad bank would just shift loans “from one government pocket (the public sector banks) to another (the bad bank) and did not see how it would improve matters”.
    • Indeed, if the bad bank were in the public sector, the reluctance to act would merely be shifted to the bad bank.
    • Alternatively, if the bad bank were to be in the private sector, the reluctance of public sector banks to sell loans to the bad bank at a significant haircut would still prevail.

    Alternatives to a bad bank

    • Many experts argue that the enactment of IBC has reduced the need for having a bad bank, as a transparent and open process is available for all lenders to attempt insolvency resolution.
    • The view is that an IBC-led resolution, or sale of bad loans to ARCs already existing, is a better approach to tackle the NPA problem rather than a government-funded bad bank.

    Former RBI Deputy Governor Viral Acharya has proposed two models:

    1) Private Asset Management Company

    • The first model is a Private Asset Management Company (PAMC) which would be suitable for sectors where the stress is such that assets are likely to have economic value in the short run, with moderate levels of debt forgiveness.

    2) Setting up National Asset Management Company (NAMC)

    • The second model is a NAMC for sectors where the problem is not just of excess capacity, but possibly also of economically unviable assets in the short- to medium-term, such as in the power sector.
    • The NAMC would raise debt for its financing needs, keep a minority equity stake for the government, and bring in asset managers such as ARCs and private equity to manage and turn around the assets.

  • Agreement for Emergency Response Programme for MSME

    The World Bank and the Government of India signed the $750 million agreement for the MSME Emergency Response Programme to support increased flow of finance into the hands of micro, small, and medium enterprises (MSMEs), severely impacted by the COVID-19 crisis.

    How will the agreement protect the MSME sector

    1. Unlocking liquidity

    • The Government is focused on ensuring that the abundant financial sector liquidity available flow to NBFCs and that banks.
    • Banks and NBFCs have turned extremely risk-averse.
    • This project will support the Government in providing targeted guarantees to incentivize NBFCs.
    • Project will also support banks to continue lending to viable MSMEs to help sustain them through the crisis.
    • It will be achieved by de-risking lending from banks and Non-Banking Financial Companies (NBFCs) to MSMEs.
    • This derisking will be done through a range of instruments, including credit guarantees.

    2. Strengthening NBFCs and SFBs

    • Improving the funding capacity of the NBFCs and Small Finance Bank (SFBs), will help them respond to the urgent and varied needs of the MSMEs.
    • This will include supporting government’s refinance facility for NBFCs.
    • In parallel, the IFC is also providing direct support to SFBs through loans and equity.

    3. Enabling financial innovation

    • Only about 8 percent of MSMEs are served by formal credit channels.
    • The program will incentivize and mainstream the use of fintech and digital financial services in MSME lending and payments.
    • Digital platforms will play an important role by enabling lenders, suppliers, and buyers to reach firms faster and at a lower cost.
    • The digital platform will be helpful especially to small enterprises who currently may not have access to the formal channels.

  • How to counter China

    There is no doubt that an economically prosperous India will be well placed to deal with China effectively. So, to achieve this prosperity India urgently needs to embark upon the path of reforms. 

    How much China has moved ahead

    • In 1987, both countries’ nominal GDPs were almost equal.
    • China’s economic opening-up has left India behind, contributing to a military imbalance.
    • China’s economy was nearly five times larger than India’s in 2019.
    • Not coincidentally, from rough parity in 1989, China’s military spending last year more than tripled India’s.
    • Heightened vigilance along the LAC demands summoning scarce resources.
    • If India cannot close the economic gap and build military muscle, Beijing may feel emboldened to probe the subcontinent’s land and maritime periphery.

    Reforms: Key to progress

    • In 1991, India enacted changes allowing markets to set commodity prices.
    • But it did not similarly liberalise land, labour and capital.
    • Now, the government has delivered mixed messages about a revitalised reform agenda.
    • Some States have temporarily lifted labour restrictions.
    • Some others intend to make land acquisition easier.

    But a call for self-sufficiency could do harm

    • India emphasis on self-reliance could inhibit growth and constrain investment in a more vigorous foreign and defence policy.
    • Greater self-sufficiency is desired.
    • Home-grown manufacturing of critical medicinal ingredients or digital safeguards on citizens’ personal data would reduce vulnerabilities.
    • Imposing restriction to help the local defence industry would hamper acquisitions helping balance China.

    Competition from other countries

    • China is facing intense scrutiny for its role in the pandemic, geopolitical competition, trade wars, and economic coercion.
    • Businesses are revisiting whether or not to diversify suddenly exposed international value chains.
    • India’s competitors [like Bangladesh, Vietnam] are trying to attract the businesses shifting out form China.
    • These countries are highlighting their regulatory predictability, stable tax policies, and fewer trade obstacles.
    • While India remains outside the Regional Comprehensive Economic Partnership, competitors are wooing companies seeking lower trade barriers.
    • Asian countries are pushing ahead: Vietnam just inked a trade deal with the European Union that threatens to eat into India’s exports.

    Way forward

    • India needs increased exports and investments to provide more well-paying jobs, technology.
    • Before committing to long-term, multi-billion investments, companies often want to test India’s market through international sales.
    • Liberalisation remains the tried-and-true path to competitiveness.
    • If India can unite its people and rapidly strengthen capabilities, it will likely discover that it can deal with China effectively.

    Consider the question “Do you agree with the view that slowdown in the reforms in land, labour and capital after the reforms of 1991 restricted Indias economic progress? Give reasons in support of your argument.

    Conclusion

    The choices that India makes to recapture consistent, high growth will determine its future. Bold reforms offer the best option to manage Beijing and achieve greater independence on the world stage.

  • Differentiating FDI and trade

    Differentiating between trade and investment is necessary for reaping the benefits that come with foreign investment in firms. However, the concerns over the source of funds are not unfounded. So, some caution is warranted in dealing with FDI.

    Let’s look into the debate

    • Government is asking its citizens to aim for self-reliance.
    • So, should India continue to allow investment inflows from China? This is the debate.
    • China has invested $4 billion in Indian startups in the past 5 years.
    • This amount would be higher if funds located in tax havens with Chinese ownership are also accounted for.

    Some of the questions raised in the debate

    •  Is trade of products like buttons, crockery same as long-term foreign investments in high-risk new age technology-driven products?
    • Is it economically prudent for a country to fulfil all its capital requirements or compromise on innovation due to lack of thereof?

     Trade vs FDI

    • Trade just helps the country fulfil its requirements of those goods and services (G&S) that may not available in the country.
    • Investments provide the capital to build infrastructure that can plug the G&S deficit, even, sell it to other markets.
    • Trade just provides entry of G&S.
    • FDI inflow is a route for transferring capabilities, technology, building linkages, business capabilities etc.
    • FDI helps generate employment, public assets, tax revenues and develop markets, none of this is contributed by the trade of merchandise.
    • Foreign investment does have an adverse impact on domestic markets in the short-run by crowding out domestic competition or investment.
    • In fact, attracting FDI in employment-intensive sectors can create positive economic and social spillovers.
    • Possibilities to increase exports often arise from companies with significant levels of FDI.
    • Foreign investor exposes itself to regulatory, economic and geo-political risks of the country.

    Foreign investment in Indian firms: Two aspects to consider

    • While discussing the funding composition of the likes of Paytm, OYO hotel chain or Ola, two aspects need to be considered.
    • 1) These companies are Indian companies operating under the law of land, creating economic opportunities for the youth and contributing to the welfare of the Indian community.
    • 2) Success of these ventures is not solely due to the investment, but because of the novelty of the product offering.
    • Investments in start-ups involve high risk; the list of failed start-ups with Chinese investment is bound to be much longer.
    • In the absence of technology giants in India, we may also end up draining the brain to countries with a stronger financial ecosystem for fresh ideas.

    Apprehension over FDI in India

    • Apprehensions related to investments from any country per se, are not unwarranted in India.
    • This is mainly because history suggests foreign investment can potentially lead to economic colonisation.
    • However, times have changed and so has the world order.
    • Steady inflow of investments can exist without impacting the economic or political stability of the country.
    • To do so we should practice some of the following recommendations.

    How to address the concern over FDI

    • Investment funds can be set up outside the home country of the investor or be routed through companies located at tax havens.
    • It is not always possible to map the investor to the country.

    How to solve this problem

    • To solve this identify sectors based on sensitivity, the investment required, technology, employment and social impact.
    • Tighten regulations related to data storage and access by companies through data localisation in these sensitive sectors.
    • Modify the offset policy in defence to ensure a certain portion of the profits is invested in the SMEs.
    • To further India’s interests in nascent sectors such as machine learning, HealthTech, maximum period for an investor to be invested in a greenfield should be limited to 10 years.
    • All firms receiving foreign investment should have a plan to contribute to India’s exports within the product lifecycle and minimum employment generation.
    • Ease listing norms for firms so that funds through public and private placement can be raised by wholly Indian owned companies.
    •  BSE SME & Start-ups Platform has helped 322 companies raise Rs. 3,320.48 crores from the market. Start-ups should be encouraged to make use of the platform wherever possible.
    • Domestic procurement of raw material and intermediate goods has to be non-negotiable as far as possible.

    Consider the question “What are the challenges and opportunities associated with foreign investment and suggest the ways to address the challenges.”

    Conclusion

    From being treated as a ‘dumping bazaar’ to now attracting investors, India does not need to shy away from investments; it certainly needs to be wary of pure trade which limits India’s potential and drive to produce indigenously.

    Back2Basics: Offset policy

    • The offset policy, introduced in 2005, mandates foreign suppliers to spend at least 30% of the contract value in India.
    • It was first revised in 2006 and then again in 2011 and in 2016. Another round of tweaking is currently underway.

     

  • Reforming Digital policy

    Pandemic has been ravaging the economies across the globe but digital services have escaped the onslaught and are thriving. For India, this could be an opportunity. This article highlights the importance of the sector and how some proposed measures could have an adverse impact on the sector.

    Emerging trends in economies

    • Economic growth has dropped, and the competition for foreign investment is intensifying.
    • There are national campaigns to shift supply chains and the urgent necessity to reverse recessionary trends.
    • The United Nations Conference on Trade and Development just released its latest World Investment Report.
    • The report projected that FDI to developing Asian economies could drop by as much as 45%.

    Why digital services would beat this trend

    • Digital services have become critical to every 21st century economy.
    • Digital services are filling gaps when national or global emergencies interrupt more traditional modes of commerce.
    • It enables access to and delivery of a wide array of products across multiple sectors.

    How it matters for India

    • India offers undeniable potential for innovative homegrown start-ups.
    • India has a huge and increasingly digitised population.
    • Indian government policies will be key determinants in how quickly and at what level the economy attracts new investment.
    • Fostering innovation, and expanding its exporting prowess will also matter.

    Three pending measure

    • Three pending reform measures under consideration are-
    • 1) Personal Data Protection Bill (PDPB).
    • 2) The e-commerce policy.
    • 3) The Information Technology Act Amendments.

    Issues with these measures

    • These regulatory reforms seem to emphasise a focus on protecting the domestic market for domestic companies.
    • It also prioritises government access to data.
    • It may be difficult to reconcile these approaches with India’s strong interest in i) promoting data privacy ii) protecting its democratic institutions iii) encouraging FDI and India’s position as a global leader in information technology.

    India-US trade relationship issue

    • The India-U.S. trade relationship is uncertain.
    • The bilateral relationship is an important factor for greater trade and investment in digital services.
    • India and the U.S. are yet to conclude negotiation on a bilateral trade agreement that could address some digital services issues.
    • The U.S. just initiated a “Section 301” review.
    • The review seeks whether digital services taxes in 10 countries constitute “unfair” trade measures, including India’s equalisation levy.

    Consider the question “Digital services have become critical to every 21st-century economy and more so for Indian economy. In light, highlight the salience of digital services for the Indian economy and what are the issues that could affect the growth trajectory of the sector in India?”

    Conclusion

    Post-COVID-19 international cooperation and approaches to good governance in the digital sphere will be top-priority initiatives. The steps India takes now could well establish itself as a true global leader.

  • How much forex reserve is too much

    India’s foreign exchange reserves touched an unprecedented level. Being reserves, the reserves also represent the lost opportunity. This article examines the reasons for and utility of maintaining huge reserves.

    Reasons for surge in the forex reserves

    • The recent forex reserves surge was a result of two things:
    • 1) Foreign institutional investors reinvested in the Indian market in May-June after they exited their positions in panic in March.
    • 2) A global fall in fuel prices has reduced India’s oil import bill, allowing it to save up forex reserves.

    But why does India keeps huge forex reserves- 3 possibilities

    • Sufficiency of forex reserves is sometimes measured on how many months’ worth of imports a country can afford.
    • While six months is considered sufficient.
    • The RBI in December 2019 said it had enough to sustain for 10 months, the forex reserves were then $0.4 trillion.
    • Today, the cover is 12 months!
    • This is despite having a sufficient credit line from the IMF, should there be a credit shock.
    • So, there are 3 possibilities for why government maintains such huge reserves.
    • 1) Excess forex reserves are likely the government’s contingency fund, in case the economy suddenly topples.
    • The pandemic has increased the government’s insecurity.
    • 2) Another possibility is that the government is accumulating these reserves as “Plan-B” savings should its strategic disinvestment plans fail.
    • 3) Forex reserves are also likely a way for India now to maintain its global rating.
    • The fundamental use of India’s foreign exchange should be to ensure the Rupee (INR) stability.

    Stability of Rupee

    •  Despite steadily rising reserves, INR fluctuated between 77 and 75 against the US dollar in the last two months.
    • INR has become one of Asia’s worst currencies.
    • The RBI may allow it to devalue further to support its balance sheet,
    • Devaluation would enable it to transfer a big chunk of its realised profits as dividend to the starving government.

    Lost opportunity

    • It is understandable for oil-rich countries to maintain high forex reserves.
    • A single oil trade hiccup can derail their economy.
    • Economists have theorised that holding high forex reserves is unnecessary.
    • In fact, not using them to finance mega infrastructure projects are lost opportunities.
    • And yet the Indian government has held these reserves in liquid, possibly for its feared D-day.

    Perils of using forex reserves as emergency funds

    •  Over-reliance on these floating funds to stimulate the economy might be poorly informed.
    • The potential of these funds to switch direction [i.e. they could exit as fast] should not be underestimated.
    • In March alone, foreign institutional investments in India fell by Rs 65,000 crore.
    • India’s foreign exchange reserves registered this impact.
    • Reversing the dip, investments went up in May and now in June with some big corporate deals.
    • If the government intends to use forex reserves as an emergency fund, it should ensure that they do not shrink just when they are most needed.

    Consider the question “India’s foreign exchange reserves touched new height recently. This also giver rise to the argument of lost opportunity. In light of this discuss the utility of maintaining foreign exchange reserves and issue of optimum level of foreign exchange reserves.”

    Conclusion

    Maintaining high foreign exchange reserves definitely entails cost. The cost-benefit analysis and the lost opportunity must be the basis for deciding the level of the reserves.

  • Stamp Duty on Mutual Fund Purchases

    The Amendments in the Indian Stamp Act, 1899 has been brought through Finance Act 2019 for Rationalized Collection Mechanism of Stamp Duty across India with respect to Securities Market Instruments.

    Up till now, we knew that stamp duties are levied on property transactions, registrations etc. With the Finance Act 2019, the stamp duties are also levied on Mutual Funds.

    What is Stamp Duty?

    • Stamp duty is a legal tax payable in full and acts as evidence for any sale or purchase of a property. It is payable under Section 3 of the Indian Stamp Act, 1899.
    • The levy of stamp duty is a state subject and thus the rates of stamp duty vary from state to state.
    • The Centre levies stamp duty on specified instruments and also fixes the rates for these instruments.
    • It is usually paid by the buyer with regardless of agreement and in case of property exchange, both seller and the buyer has to share the stamp duty equally.
    • A stamp duty paid instrument/document is considered a proper and legal instrument/document and has evidentiary value and is admitted as evidence in courts.

    What is the move?

    • Beginning July 1, all shares and mutual fund purchases will attract a stamp duty of 0.005 per cent and any transfer of security will attract a stamp duty of 0.015 per cent.
    • The government had introduced changes to the Stamp duty Act last year by introducing a uniform rate of stamp duty on the trading of shares and commodities.
    • All categories of mutual funds (except for ETFs) will attract stamp duty for the first time.
    • Shares purchased by individuals at stock exchanges were charged stamp duty at different rates by respective states.

    Where all will it be applicable?

    • The stamp duty will be applicable on all transactions, including shares, debt instruments, commodities and all categories of mutual fund schemes.
    • As for mutual funds, it will be applicable on all fresh purchases, including the fresh monthly purchases in previously registered Systematic Investment Plans.
    • It will also be applicable if investors switch from one scheme to another and also in case of dividend reinvestment transactions.
    • Transfers of units from one Demat account to another, including market/off-market transfers, will also attract stamp duty.

    How does it impact the investor?

    • The impact on long-term investments by a retail investor is nominal.
    • Since the stamp duty will be charged a one-time charge, if an investor invests Rs 1 lakh in a mutual fund scheme or in stock and holds it for two years, he will have to pay a duty of only Rs 5.
    • In fact, it will be marginally lower as the stamp duty is applicable on the net investment value i.e gross investment amount less than any other deduction like transaction charge.
    • There is no duty at the time of redemption.

    What about big investors?

    • The impact is higher for investors with short-term investment horizons such as banks and corporates who invest in liquid and overnight schemes of mutual funds.

    How much revenue can it generate for the government?

    • In the financial year 2019-20, the mutual fund industry mobilized aggregate funds of over Rs 188 lakh crore.
    • A high portion of that was in overnight funds or liquid funds.
    • A 0.005 per cent stamp duty on this amount works out to Rs 940 crore.
    • If the industry continues to mobilise funds to the tune of Rs 190 lakh crore or higher, it will generate revenues of nearly Rs 1,000 crore for the government from mutual fund transactions itself.

    Back2Basics: Mutual Funds

    • MF is a trust that collects money from a number of investors who share a common investment objective.
    • Then, it invests the money in equities, bonds, money market instruments and/or other securities.
    • Each investor owns units, which represent a portion of the holdings of the fund.
    • The income/gains generated from this collective investment are distributed proportionately amongst the investors after deducting certain expenses, by calculating a scheme’s “Net Asset Value or NAV.
    • It is one of the most viable investment options for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.
    • All funds carry some level of risk. With mutual funds, one may lose some or all of the money invested because the securities held by a fund can go down in value.

  • Why spending on infrastructure matters

    Spending on infrastructure can help kickstart the economy. This article highlights the importance of spending on infrastructure and suggests ways to find resources.

    Gloomy prospects for Indian economy

    • The IMF estimates the global economy to contract by -4.9 per cent this year.
    • It could still contract should the virus not recede in the latter half of 2020.
    • As for the Indian economy, growth has been decelerating for the past eight quarters.
    • Indications by the RBI suggest that growth is contracting for the first time in four decades.
    •  We must address the elephant in the room — the need to further aid a demand recovery as the economy begins to reopen.

    Components of Indias growth

    • Growth in the Indian economy has been dominated by the following components respectively-
    • 1) Consumption.
    • 2) It is followed by investments.
    • 3) Government expenditure.
    • 4) Net exports.
    • However, consumption and investment demand have been subdued for the past few quarters, dragging down overall growth.
    • Keynesian theory suggests that for aggregate demand to increase, at least one of the components of GDP needs to expand.

    Declining consumption demand

    • These two components were perhaps casualties of a sharp deceleration in credit supply.
    •  The IL&FS debacle in September 2018 only made matters worse.
    • The NBFC sector, suffered from funding crunches leading to a further squeeze in credit supply.
    • Freeze in credit supply impacted consumption demand.
    • This deceleration is likely to exacerbate going forward.

    Declining rate of investment

    • Broad-based utilisation levels, as represented by the RBI, dropped to 68.6 per cent in Q3FY20.
    • This is well below the 75 per cent benchmark for new capacity addition, implying suboptimal levels of fresh investments.
    • A higher rate of investments is essential for sustainable economic growth.
    • The deteriorating economic scenario and increasing levels of debt with rating downgrades for industries are likely to aggravate existing problems.

    Importance of expenditure on spending on infrastructure

    • Government expenditure is the only exogenously determined element in a Keynesian framework.
    • The positive push required to aid a demand recovery has to come through the government.
    • However, with sparse resources that India has, we must deploy funds that yield a higher return.
    • One key area that can provide the necessary support is infrastructure investment.
    • A study by S&P Global estimates 1 per cent of GDP spend on infrastructure can boost real growth by 2 per cent while creating 1.3 million direct jobs.
    • Historically, countries have used infrastructure to provide counter-cyclical support to the economy.
    • Notably, infrastructure has strong links to growth and with both supply and demand-side features that help generate employment and long-term assets.
    • India already has an upper hand here.
    • Front-loading key projects with greater visibility from the recently announced National Infrastructure Pipeline (NIP) could aid in a quicker recovery.

    Special infrastructure bond

    •  India already has several institutions for infrastructure development purposes from the likes of IIFCL, IRFC to more recently NIIF.
    • Taking a cue from China, floating special infrastructure bonds through this organisation to accelerate the funding of the NIP could aid a speedier recovery.
    • Further, taking a page from the New Deal and its Reconstruction Finance Corporation, this institution’s ability for greater leverage can be used to make amends to our credit channels.
    • This ability could also be used for the development of state government and urban local body bond markets.
    • This could help businesses and bankers overcome risk aversion and bring back trust in the system while financing new paths for growth.

    Consider the question “Highlight the role of consumption and investment as the two largest contributors to India’s growth and explain how spending on the infrastructure could help revive the economy hit hard by the pandemic”

    Conclusion

    The exogenous component in the form of spending by the government could step-in in a greater way, perhaps because, it is the only one that can.

  • Governance of the commercial banks

    This article discusses the nitty-gritty of the recently released discussion paper by the RBI on governance. Governance in the commercial bank has been in the news following the failures of some banks.

    Discussion paper by RBI

    • Recently RBI released a discussion paper on ‘Governance in Commercial Banks in India’.
    • Recently there have been high-profile instances involving governance failures in certain banks.
    • These instances have called into question the adequacy of the existing legal regime for ensuring good governance in commercial banks.
    • Internationally, the question of governance norms in banks is treated differently given the complex nature of functions performed by banks in comparison to other businesses.
    • Functions of the banks make them critical for allocation of resources in the economy, protection of consumer interests and maintenance of financial stability.

    Objectives of the discussion paper

    • The stated objective of the discussion paper is to align the current regulatory framework on bank governance with global best practices.
    • Best practices include the guidelines issued by the Basel Committee on Banking Supervision and the Financial Stability Board.

    Current regulatory framework

    • To this end, RBI adopts international standards for bank governance into the general corporate governance framework in India.
    • This general governance framework comprises the Companies Act, 2013, and the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Requirements, 2015.
    • These governance norms focus on the responsibilities of the board of directors, board structure and practices.
    • And it also includes aspects of risk management, internal audit, compliance, whistle-blowing, vigilance, disclosure and transparency.

    Issue of connection between management and owner

    • RBI also constituted an internal working group to review the extant regulatory guidelines relating to ownership and control in private sector banks.
    • This group is expected to submit its report by September 30, 2020.
    • But the assumption that deeper connections between the management and the owners necessarily lead to mismanagement needs to evaluated carefully and recalibrated to ensure balanced reforms.
    • The governance risks attributable to such connections might be relevant for government-owned banks as well.

    Key recommendations in the paper

    • (1) The majority of a commercial bank’s board must comprise of independent directors.
    • This is a standard higher than that prescribed under the Companies Act and the SEBI Regulations.
    • (2) The chairperson of the board must be an independent director.
    • (3) Chairpersons of crucial board committees (the audit committee, the risk management committee and the nomination and remuneration committee) must be independent directors who are not chairpersons of any other board committee.
    • (4) The tenures of non-promoter CEOs and WTDs should be limited to 15 years.

    Way forward

    • In order to make the reform effective, the appointment process for independent directors also needs to be re-evaluated to limit the role of controlling-shareholders.
    • The liability regime for directors on the boards of banking companies should also be revisited to balance the rights and liabilities of the directors.
    • The efficacy of implementation of norms as prescribed will depend on adequate enforcement.
    • The findings of the report of the working group have to be considered to formulate a comprehensive and effective governance framework for commercial banking in India.

    Consider the question “Given the complex nature of functions performed by the banks in comparison to other businesses subjecting them to stricter norms of governance is necessary. In light of this examine the adequacy of existing governance norms and suggest ways to improve them.”

    Conclusion

    RBI must exercise caution to ensure that the reforms balance the interests of all the stakeholders and do not come at the cost of discouraging investments and entrepreneurship in the Indian banking industry.

  • Is printing money an option to tide over the crises

    India has been dealing with unprecedented crises-with China on border and with economy and pandemic within. Fighting these crises require resources. So, this article examines the options to raise revenue and the consequences that come with them.

    Increase in financial burden to counter China

    •  The Chinese military threat calls for immediate and strategic action by our defence and foreign affairs establishments.
    • India’s war against Pakistan in Kargil in May 1999 provides hints of the financial burden of a military threat.
    • India’s defence expenditure in the war year shot up by nearly 20% from the previous year.
    •  India’s defence budget for the next financial year was 2.7% of nominal GDP, the highest in decades.
    • China is a far mightier power than Pakistan.
    • India’s defence budget has been whittled down to just 2% of GDP for the financial year 2021.
    • China’s defence budget is nearly four times larger.
    • In all likelihood, the Chinese conflict will stretch central government finances by an additional one to two percentage points of GDP.

    Economics of healthcare

    •  The combined public health expenditure of States and the central government in India is a mere 1.5% of GDP.
    • While China’s is at 3% and America’s at 9%.
    • The COVID-19 epidemic is expected to linger on for another two years.
    • There is no option other than to significantly ramp up India’s health expenditure.
    • So, government will need additional funds of the equivalent of at least one percentage point of GDP to continue the fight against COVID-19.

    But economy is in bad shape

    • India’s economy has four major drivers: 1) Spending on consumption. 2) Government spending. 3) Investment. 4) external trade.
    • Spending by people is the largest contributor to India’s economic growth every year.
    • For every ₹100 in incremental GDP, ₹60 to ₹70 comes from people’s consumption spending.
    • The lockdown shut off people from spending for two full months.
    • India’s economy will contract for the first time in nearly five decades.
    • With the global economy in tatters, trade is not a viable alternative to offset the loss from consumption.
    • Investment is also not a viable option at this stage since the demand for goods and services has fallen dramatically.

    So, what we want is new “New Deal”

    • There are only two options to come out of this situation.
    • 1) Either put money in the hands of the needy to stimulate immediate consumption.
    • 2) Or, the government has to embark on a massive spending spree, akin to the “New Deal”.
    • New Deal was a series of programmes and projects instituted in the U.S. during the Great Depression of the 1930s.
    • Government will need to inject incremental funds of five percentage points of GDP to absorb the economic shock and kick start the spending cycle again.

    Findind resources while aoiding “junk rating”

    • Additional expenditure on health, defence and stimulus package plus making up for a shortfall in revenue will lead to a fiscal deficit of 10% of GDP.
    • The only option for the government to finance its needs is to borrow copiously.
    • Borrowing will obviously push up debt to ominous levels.
    • When government debt rises dramatically, it gives rise to a “junk” crisis.
    • With rising debt levels, international rating agencies will likely downgrade India’s investment rating to “junk”.
    • Junk rating will then trigger panic among foreign investors.
    • India thus faces a tough dilemma — save the country’s borders, citizens and economy or prevent a “junk” rating.

    Is printing money an option?

    • Economic theory states that if money is printed at will, it can lead to a massive spike in prices and inflation.
    • This theory has fallen flat in the past decade in developed nations such as America.
    • The U.S dollar, by virtue of being the world’s reserve currency, has in-built protection against a currency crisis that can be triggered by at-will printing of money.
    • India don’t have that protection.
    • Hence, the Reserve Bank of India can just create money at will and transfer them to government coffers electronically, some argue.
    • Whether money is printed or borrowed from others, it will still be counted as government debt.
    • And so, cannot escape a potential downgrade to a “junk” rating.

    Consider the question “As the government has been dealing with the unprecedented crises, it has to explore the option of monetisation of its debt. Examine the issues with such a move.”

    Conclusion

    How India emerges from this crisis will shape not just India’s destiny but the world’s. The best course of action is to borrow unabashedly to pull India out of the crisis and deal with the consequences of a potential “junk” nation label.