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GS Paper: Indian Economy

  • Communication gap between the MPC and RBI

    Context

    Communication is a critical element of monetary policy. Yet there seems to be a gap between what the MPC says and what the RBI does.

    About MPC

    • The Reserve Bank of India Act, 1934 (RBI Act) has been amended by the Finance Act, 2016,  to provide for a statutory and institutionalised framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth.
    • Highest monetary policy-making body: By law, the Monetary Policy Committee is the highest monetary policy-making body in the land, tasked with deciding monetary policy changes at regular intervals.
    • Composition: The MPC will have six members – the RBI Governor (Chairperson), the RBI Deputy Governor in charge of monetary policy, one official nominated by the RBI Board and the remaining three members would represent the Government of India.
    • The MPC will be chaired by the Governor.
    • Under the inflation targeting regime, the most important role in communication belongs to the MPC.

    Communication with public

    • Monetary policy changes are communicated through formal statements, with the discussions underlying these decisions also being published, so that the public can understand why the MPC decided the way that they did.
    • Communication gap: Over the past few years, a communication gap seems to have opened up between what the MPC has been saying and what the RBI has been doing, thereby potentially eroding the credibility of the IT framework.
    • Influencing inflation expectations: Communication is an important part of the ability of the central bank to influence inflation expectations. 

    Following are the ways which indicate the communication gap between the RBI and the MPC, with several implications for the credibility of the MPC.

    1] Separate statements

    • During the first few years of the inflation-targeting regime from 2016 to 2018, the process of communication worked quite well.
    • On the days of policy announcements, the governor and his deputies would participate in a press conference.
    • From 2019 onwards, however, things began to change.
    • Governor’s separate statement: The RBI began to release a separate governor’s statement on the day of the monetary policy meeting, presenting an inflation outlook and even explaining the decision taken by the MPC.
    • MPC statement: It has overlapped with the MPC statement; at times, it has seemed somewhat different.
    • For example, following the June 8 Monetary Policy Review the MPC highlighted inflation concerns, and voted in favour of raising the policy repo rate.
    • On the same day, a governor’s statement mentioned that the central bank will also remain focussed on the orderly completion of the government’s borrowing programme.
    • Confusion: The issuance of two such different statements can lead to confusion, especially as lowering inflation and lowering government bond yields are contradictory policy objectives.

    Why is communication so crucial? To influence inflation expectations!

    • If the public believes the central bank is committed to keeping inflation under control, then it will act accordingly.
    • Firms will moderate their price increases, fearing that large price rises will make them uncompetitive.
    • Meanwhile, workers will accept moderate wage increases, while investors will accept low interest rates on their bond purchases.
    • With everyone acting in this way, it will be easier for the central bank to ensure that inflation indeed remains low.
    • Anchored inflation expectations: If inflation expectations are well anchored, then it becomes relatively easy for the central bank to ensure that inflation returns to the target level before too long.

    2] Change in the Monetary Policy Corridor width during pandemic

    • Deciding the repo rate: The most important task of the MPC, enshrined in the RBI Act (Amended), 2016 that introduced IT, is to decide the repo rate, since this has long been the lynchpin of India’s monetary policy framework.
    •  Ever since the early 2000s, policy had aimed to keep overnight money market rates in a corridor, with the lower bound established by the reverse repo rate and the upper bound by the repo rate.
    • Since the width of this corridor was fixed, once the repo rate was decided, the reverse repo rate was automatically determined, and market overnight rates adjusted accordingly.
    • During the Covid-19 pandemic, the RBI constantly adjusted the reverse repo rate even as the MPC kept the repo rate unchanged.
    • As a result, the fixed width of the corridor was lost, and the MPC lost any role in determining interest rates.

    3] Introduction of policy instruments outside the remit of MPC

    • During pandemic, the RBI introduced a number of new policy instruments, again outside the remit of the MPC.
    • GSAP: It brought in the GSAP programme through which it pre-commited to buying a certain amount of dated government bonds in order to control their yields.
    • Variable reverse repo auctions: It then introduced variable reverse repo auctions, and more recently, replaced the reverse repo rate with the long-dormant standing deposit facility rate.
    • The rationale for this was not explained in the MPC statement.
    • All unconventional monetary policy announcements were kept outside the MPC statement.
    • This raised the questions about the role of the committee in deciding monetary policy actions at a crucial time like the pandemic.

    4] Intervention in the foreign exchange market

    • The RBI has been intervening in the foreign exchange market to manage the rupee.
    • Forex interventions by definition influence the domestic monetary base and inflation.
    • Yet the MPC in its monetary policy statements does not discuss either the exchange rate dynamics or the forex interventions.
    • Just as it does not discuss the RBI’s interventions in the bond market to lower the yields.

    Way forward

    • In its latest two statements, the MPC indicated that policy would now be focusing on bringing India’s inflation rate under control.
    • Clear policy framework: If the RBI is going to be successful in this endeavour, the first step must be to close the communication gap, by reintroducing a simple and clear policy framework and restoring the central role of the MPC.

    Conclusion

    The net result of all these actions is a potential loss of both clarity and credibility. The communication gap will need to be closed in order for the RBI to become successful in bringing inflation back to its 4 per cent target level.

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    Back2Basics: Monetary Policy Corridor

    • The Corridor in the monetary policy of the RBI refers to the area between the reverse repo rate and the MSF rate.
    • Reverse repo rate will be the lowest of the policy rates whereas Marginal Standing Facility is something like an upper ceiling with a higher rate than the repo rate.
    • The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.
    • As per the monetary policy of the RBI, ideally, the call rate should travel within the corridor showing a comfortable liquidity situation in the financial system and economy.

    What is GSAP?

    • The G-Sec Acquisition Programme (G-SAP) is basically an unconditional and a structured Open Market Operation (OMO), of a much larger scale and size.
    • G-SAP is an OMO with a ‘distinct character’.
    • The word ‘unconditional’ here connotes that RBI has committed upfront that it will buy G-Secs irrespective of the market sentiment.

  • India better placed to avoid Risks of Stagflation: RBI

    India’s economy is better placed than many other countries to avoid the risk of potential stagflation worldwide, said the Reserve Bank of India Deputy Governor.

    Why in news?

    • Stagflation remains a risk to the US economy, and there are similarities between the situation in the 1970s and today, a/c to World Bank.
    • Surging prices for oil and food are pushing up the cost of living, and business executives are voicing concerns about the outlook for the economy.

    What is Stagflation?

    • Stagflation is a stagnant growth and persistently high inflation. It, thus, describes a rather rare and curious condition of an economy.
    • Iain Macleod, a Conservative Party MP in the United Kingdom, is known to have coined the phrase during his speech on the UK economy in November 1965.

    What happens in Stagflation?

    • Typically, rising inflation happens when an economy is booming — people are earning lots of money, demanding lots of goods and services and as a result, prices keep going up.
    • When the demand is down and the economy is in the doldrums, by the reverse logic, prices tend to stagnate (or even fall).
    • But stagflation is a condition where an economy experiences the worst of both worlds — the growth rate is largely stagnant (along with rising unemployment) and inflation is not only high but persistently so.

    Possible reasons behind

    • Volatility due to war: Global economic conditions continued to deteriorate as commodity prices and financial market volatility have led to heightened uncertainty.
    • Monetary tightening: In advanced economies, the war against inflation would entail significant monetary tightening, complicating the growth-inflation outlook.
    • Global slowdown: Emerging market economies grapple with the global trade slowdown, capital outflows and imported inflation.

    Why is it so unpopular?

    • The combination of slow growth and inflation is unusual, because inflation typically rises and falls with the pace of growth.
    • The high inflation leaves less scope for policymakers to address growth shortfalls with lower interest rates and higher public spending.

    Back2Basics: Inflation and its impact

    • Depression: It is Economic depression is a sustained, long-term downturn in economic
    • Deflation: It is the general fall in the price level over a period of time.
    • Disinflation: It is the fall in the rate of inflation or a slower rate of inflation. Example: a fall in the inflation rate from 8% to 6%.
    • Reflation: It is the act of stimulating the economy by increasing the money supply or by reducing taxes, seeking to bring the economy back up to the long-term trend, following a dip in the business cycle. It is the opposite of disinflation.
    • Skewflation: It is the skewed rise in the price of some items while remaining item prices remain the same. E.g. Seasonal rise in the price of onions.
    • Stagflation: The situation of rising prices along with falling growth and employment, is called stagflation. Inflation is accompanied by an economic recession.

     

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  • The uneven toll of inflation

    Context

    This upsurge of inflation is affecting the poor more than any other social group because some of the commodities whose prices are increasing the most (like petrol and certain food items) represent a larger fraction of the budget of the most vulnerable sections of society.

    Factors fueling inflation in India

    • The Wholesale Price Index (WPI) and the Consumer Price Index (CPI) show an upward rising trend, annually, at 13.11 per cent and 6.07 per cent respectively.
    • Falling rupee: Inflation is here to stay because it has much to do with the decline in value of the rupee that has fallen to its lowest, which makes imports of oil and gas more expensive.
    • Ukraine crisis: The war in Ukraine has the same effect and pushes the price of some food items upward.

    Rising inequality

    • Impact on the poor: This upsurge of inflation is affecting the poor more because some of the commodities whose prices are increasing the most represent a larger fraction of the budget of the most vulnerable sections of society.
    • Rising inequality: As a result, inequalities — which were already on the rise — are increasing further.
    • Recently, the State of Inequality in India report showed that an Indian making Rs 3 lakh a year belonged to the top 10 per cent of the country’s wage earners. 
    •  Inequalities are also increasing among salaried people, who are privileged compared to those of the informal sector: The bottom 50 per cent account for only 22 per cent of the total salary income.
    • The situation of the lower-middle class and poor is deteriorating.
    • The Reserve Bank of India shows slow farm wage growth in nominal terms: From an average of 6.6 per cent in fiscal 2021 to 5.7 per cent in fiscal 2022 (April-November average). This is below the inflation rate.

    Inequality in healthcare

    • India’s spending on healthcare is among the lowest in the world.
    • A decent level of healthcare is available only to the ones who can afford it because of increasing out-of-pocket expenditure — the payment made directly by individuals for the health service, not covered under any financial protection scheme.
    •  Overall, these out-of-pocket expenses on healthcare are 60 per cent of the total expenditure on public health in India, which is one of the highest in the world.

    How policies are contributing to the increasing inequality?

    • High indirect taxes: The share of indirect taxes in the state’s fiscal resources has increased from 2014 to 2019 to reach 50 per cent of the total taxes in 2019.
    • Higher indirect taxes are the most unfair as it affects everyone, irrespective of their income.
    • Taxes on alcohol and petroleum products are cases in point.
    • In contrast, the big companies are flourishing, again, partly because of certain fiscal policies. 
    • Low corporate taxes: The government’s budget in 2015 substantially lowered the corporate tax.
    • Withdrawal of enhanced surcharge: In addition to these tax cuts, the government withdrew the enhanced surcharge on long- and short-term capital gains for foreign portfolio investors (FPIs) as well as domestic portfolio investors.
    • These government policies are clearly promoting the supply side at the expense of demand.
    • The central bank has raised interest rates and CRR in an attempt to curb demand, but demand in the country is already choking.

    Way forward

    • Higher allocation for MGNREGA: A higher allocation of funds for MGNREGS in rural areas, as well as the introduction of similar employment generation schemes in urban areas, should, therefore, be a priority.
    • Municipal bonds at state level: At the state level, the development of municipal bond markets could be a plausible alternative.
    • Reduction on excise duty on fuel: A reduction in the excise duty on fuel prices and easing the fuel tax burden could also supplement the disposable income and reduce the input cost burden for producers.

    Conclusion

    Though the government is opting for market-based economics, currently, India needs a mixed solution that comprises price stability via government channels and subsidies.

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    Back2Basics: Long and short-term capital gain

    • When you buy and sell assets, the profit that you earn is called a Capital Gain.
    • Long Term Capital Gains are those that you earn when you sell an asset after 36 months (3 years) from the date on which you acquired the asset.
    • Short Term Capital Gains are those that you earn when you sell an asset in under 36 months (3 years) from the date on which you acquired the asset.

  • Freebie model of Governance

    Context

    The newly elected Punjab government’s announcement of providing up to 300 units of free power to every household has raised questions: What constitutes “freebies”?

    Two categories for providing support

    • In India government provides two types of support.
    • 1] support to low-income households for augmenting their consumption of selected goods and services.
    • 2] Government also provides incentives to support selected categories of investors and producers.
    • Different objectives: The economic objectives in these two categories are quite different.
    • The first category would include the free or subsidised provision of foodgrains and services such as health and education.
    • Examples of the second group include the central government’s recent initiative for production-linked incentives to various sectors and tax concessions.
    • In the past, incentives in the form of reduction of corporate taxes have been offered to promote investment in general, or in certain regions such as backward areas.

    What commodities should be distributed free?

    • The key question is to decide what commodities should be distributed free or at a subsidised level and what the level of subsidy should be.
    • Essential goods: The provision of foodgrains at a heavily subsidised price to target groups has found general acceptance, particularly among political parties, even though there are some critics of the measure.
    • The distribution of commodities which are considered “essential”, primarily foodgrains, faces no criticism.
    • Merit goods: There is also a category of goods which are called “merit” goods where significant positive externalities are associated with their consumption — for instance, health and education-related provisions, including mid-day meals and breakfast.
    • In such cases, subsidisation is justified: If only market prices prevail, the community will consume less than what is socially desirable.

    What should be the suitable mode of providing support?

    • The question of a suitable model for providing budgetary support arises in the context of both consumption and production-supporting initiatives.
    • 1] In the first case, budgetary support to a targeted segment of the population for augmenting their consumption of essential items may be provided either through direct income support or by a free or highly subsidised provision. 
    • Procurement set up and distribution system: When the provision of subsidised goods is involved, there may, in general, be a requirement of a procurement set-up and a public distribution system.
    • Managing procurement and distribution by government agencies involves additional costs which tend to be higher than the corresponding supply through the market because of leakages and avoidable administrative costs.
    • 2] Production-related incentives: In the case of production-related incentives, alternative methods include direct budgetary support and indirect support through tax concessions.
    •  Both have a differential impact.
    • These schemes also require to be carefully designed to avoid their misuse and minimise their costs. The provision of free power to farmers was often misused.
    • In the case of tax concessions, there have not been any convincing studies as to whether the stated initial objectives were achieved in line with the large budgetary costs.
    • The magnitudes involved amounted to 1.9 per cent and 2.5 per cent of the GDP in 2018-19 and 2019-20 respectively.

    What should be a prudent fiscal limit for funding such programmes?

    • Let us consider the case of distribution of commodities that are meant to support consumption.
    • Limited budgetary resources: This question should be considered in light of our limited budgetary resources.
    • Stagnating revenue to GDP ratio: In India, the revenue to GDP ratio has been stagnating over a long period of time.
    • During 2010-11 to 2019-20, combined revenue receipts of central and state governments, relative to GDP, have languished in the narrow range of 18.4 per cent to 20.3 per cent.
    • In contrast, in many developed and emerging market economies, this ratio tends to be much higher.
    • In 2019, these ratios were 36 per cent and 30.1 per cent for the UK and USA.

    Suggestions

    • It is advisable to limit the distribution of commodities and services at highly subsidised levels to essential and merit goods.
    • Infrastructure expansion: Production may be incentivised more effectively by other methods such as infrastructure expansion.
    • Determining the total quantum of support: In respect of production-related incentives also, greater care is required for determining the total quantum of support as well as the specific forms of such support.
    • Limit of 10 %: It would be prudent to limit overall fiscal support for the distribution of commodities to less than 10 per cent of the total expenditure of the central government and state governments until their revenue GDP or GSDP ratios are successfully increased in a sustained way.

    Conclusion

    Governments that do not pay adequate attention to the strength of their fisc eventually become exposed to the cost of the choices that they make.

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    Back2Basics: Merit goods

    • Merit goods are the goods that are provided generally by the government to certain sections of the society.
    • Unlike in the case of pure public goods, the merit goods are not provided to the entire society; rather they are given to certain targeted people.
    • The government here believe that the deserving people may under-consume such goods and hence provides these to them at low cost or no cost.

    Positive externalities

    • A positive externality exists if the production and consumption of a good or service benefits a third party not directly involved in the market transaction.
    • For example, education directly benefits the individual and also provides benefits to society as a whole through the provision of more informed and productive citizens.

  • India specific factors that have bearing on inflation trajectory

    Context

    Inflation is turning into a global concern fueled by multiple global factors. However, in India there are a few other triggers that will have a bearing on the inflationary trajectory.

    Global inflation concerns

    • All that could have possibly triggered higher inflation globally has already occurred — multiple waves of the pandemic, supply disruptions, an overdose of policy stimuli, war, sanctions, energy shocks, geopolitical adversity and weather disruptions.

    1] Impact of MSP on inflation

    • The MSP that is fixed by the government for kharif and rabi crops has been one of the key policy instruments.
    • Policymakers in India have often acted with alacrity to protect the interests of farmers over the years.
    • In the last 20 years, the weighted average MSP for kharif crops saw double-digit growth four times — in 2007, 2008, 2012 and 2018.
    • Food inflation shot up to 12 per cent in 2007-08 as against 8 per cent in 2006-07 and 4 per cent in 2005-06.
    • The inflationary surge continued in 2009 as a monsoon failure hit agricultural output hard.
    • Global agricultural commodity prices started to rise in 2010 again and the FAO food price index reached an all-time high in July 2012.
    • One of the key reasons for the increase in food prices was the oil price surge and a rise in demand for biofuel production.
    • The global upside in food prices coincided with a 22 per cent increase in MSP for Kharif crops in India.
    • Following the rise in MSP, food inflation in 2012 increased by 14.6 per cent as against 3.6 per cent the preceding year.
    • In  2018, for the first time, the MSPs for all 23 kharif and rabi crops were fixed at a margin of at least 50 per cent higher than the cost of cultivation.
    • The cost of cultivation (A2 + FL) includes the paid-out cost and cost of imputed family labour.
    • Accordingly, the MSP of kharif crops in 2018 saw an annual increase of about 14 per cent.
    • However, despite the significant rise in MSP, food inflation in 2018-19 was muted at 0.3 per cent.
    • This was because farm input costs were under control and the terms of trade for farmers remained positive.

    2] Impact of GST on inflation

    • Raising the revenue-neutral rate: In the upcoming meeting, there is talk of changes in GST slabs and rates with an eye on raising the revenue-neutral rate from around 11.5 per cent, which is far lower than the 15.5 per cent estimated at the time of the launch of GST.
    • Avoid the shock: However, a GST rate shock to the system is best avoided given the global inflationary backdrop and the fragility of consumer balance sheets.

    3] Influence of weather

    • While the dependence of agricultural output on the quantum of rainfall has reduced, variance in the spatial and temporal distribution of rainfall is emerging as a key risk.
    • A look at 2021 — a normal monsoon year with rainfall at 99 per cent of its long period average — is instructive.
    • The late excess rains delayed the crop cycle and led to crop damage in several parts of the country.
    • Likewise, the spatial distribution of rainfall remained uneven in 2021.
    • Thus, even with normal rainfall in 2021, there were several disruptions to the crop cycle and farm cash flows.

    Conclusion

    The government has taken various steps lately to rein in inflation. However, the RBI will have little freedom in case the GST council decides to accord revenue protection to states via higher GST rates or if the monsoon is not in line with expectations. One hopes these events pan out right, like the MSP hike, when most other things have gone wrong.

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  • India is not the fastest growing big economy

    Context

    The Provisional Estimates of Annual National Income in 2021-22 just released show that GDP grew 8.7% in real terms and 19.5% in nominal terms (including inflation). It makes India the fastest growing major economy in the world.

    What data implies

    • Just 1.51% larger: Provisional Estimates of Annual National Income in 2021-22 also indicate that, the real economy is 1.51% larger than it was in 2019-20, just before the novel coronavirus pandemic hit the world.
    • In nominal terms it is higher by 17.9%.
    • Inflation: These numbers imply that the rate of inflation was 10.8% in 2021-22 and 16.4% between the two years, 2019-20 and 2021-22.
    • Almost no growth: This picture implies almost no growth and high inflation since the pre-pandemic year.
    • So, the tag of the fastest growing economy means little.
    • Quarterly growth rate: The quarter to quarter growth currently may give some indication of the present rate of growth.
    • In 2020-21, the quarterly rate of growth increased through the year.
    • In 2021-22, the rate of growth has been slowing down.
    • Of course in 2020-21, the COVID-19 lockdown had a severe impact in Q1 (-23.8%); after that the rate of growth picked up.
    • In 2021-22, the rate of growth in Q1 had to sharply rise (20.3%).
    • Ignoring the outliers in Q1, growth rates in 2021-22 have sequentially petered out in subsequent quarters: 8.4%, 5.4% and 4.1%.
    • Going forward, while the lockdown in China is over, the war-related impact is likely to persist since there is no end in sight.
    • Thus, price rise and impact on production are likely to persist.

    Issues with the data

    • The issue is about correctness of data.
    • The annual estimates given now are provisional since complete data are not available for 2021-22.
    • There is a greater problem with quarterly estimates since very limited data are available for estimating it.
    • No data for Q1 of 2020-21: The first issue is that during 2020-21, due to the pandemic, full data could not be collected for Q1.
    • No data for agriculture: Further, for agriculture, quarterly data assumes that the targets are achieved.
    • Agriculture is a part of the unorganised sector.
    • Very little data are available for it but for agriculture — neither for the quarter nor for the year.
    • It is simply assumed that the limited data available for the organised sector can be used to act as a proxy.
    • The non-agriculture unorganised sector is represented by the organised sector.
    • Changes in non-agriculture unorganised: The method using the organised sector to proxy the unorganised non-agriculture sector may have been acceptable before demonetisation (2016) but is not correct since then.
    • The reason is that the unorganised non-agriculture sector suffered far more than the organised sector and more so during the waves of the pandemic.
    • Shift in demand to the organised sector: Large parts of the unorganised non-agriculture sector have experienced a shift in demand to the organised sector since they produce similar things.
    • This introduces large errors in GDP estimates since official agencies do not estimate this shift.
    • All that is known is that the Micro, Small and Medium Enterprises (MSME) sector has faced closures and failures.
    • If GDP data are incorrect, data on its components — private consumption and investment — must also be incorrect.
    • Further, the ratios themselves would have been impacted by the shock of the lockdown and the decline of the unorganised sectors.
    • Private consumption data is suspect since according to the data given by the Reserve Bank of India which largely captures the organised sector, consumer confidence throughout 2021-22 was way below its pre-pandemic level of 104 achieved in January 2020.
    • In brief, neither the total nor the ratios are correct.

    Possible corrections

    • In the best possible scenario,  assume that the organised sector (55% of GDP) and agriculture (14% of GDP) are growing at the official rate of growth of 8.2% and 3%, respectively.
    • Then, they would contribute 4.93% to GDP growth.
    • The non-agriculture unorganised component is declining for two reasons: first, the closure of units and the second the shift in demand to the organised sector.
    • Even if 5% of the units have closed down this year and 5% of the demand has shifted to the organised sector, the unorganised sector would have declined by about 10%; the contribution of this component to GDP growth would be -3.1%.

    Conclusion

    Clearly, recovery is incomplete and India is not the fastest growing big economy of the world.

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  • RBI plans to link Credit Cards with UPI

    The RBI has proposed to allow the linking of credit cards with the Unified Payments Interface (UPI).

    Integrating Credit Cards to UPI

    • The integration will first begin with the indigenous RuPay credit cards.
    • Both the RuPay network and UPI are managed by the same organisation – the National Payments Corporation of India (NPCI).

    What is UPI?

    • UPI is an instant real-time payment system developed by National Payments Corporation of India (NPCI) facilitating inter-bank transactions.
    • The interface is regulated by the Reserve Bank of India and works by instantly transferring funds between two bank accounts on a mobile platform.

    Why such move?

    • The linkage of UPI and credit cards could possibly result in credit card usage zooming up in India given UPI’s widespread adoption.
    • The integration also opens up avenues to build credit on UPI through credit cards in India, where in the last few years, a number of startups like Slice, Uni, One etc. have emerged.
    • The move could also be a push to increase adoption by banking on UPI’s large user base.
    • So far, UPI could only be linked to debit cards and bank accounts.
    • This will provide additional convenience to the users and enhance the scope of digital payments.

    What could be the hurdles?

    • There are some regulatory areas that would have to be addressed before the linkage happens.
    • For instance, it is not clear how the Merchant Discount Rate (MDR) will be applied to UPI transactions done through credit cards.
    • UPI and RuPay attract zero-MDR, meaning that no charges are applied to these transactions, which is a key reason behind the prolific adoption of UPI both by users and merchants.
    • The norm has faced pushback from the payments industry.
    • It has argued that it limits the aggregators’ ability to invest in and maintain the financial infrastructure of the payment ecosystem that they have built.
    • Applicability of zero-MDR on UPI could also be a reason why other card networks such as Visa and Mastercard may not have been onboarded to UPI for credit cards yet.

    Note: MDR is a fee that a merchant is charged by their issuing bank for accepting payments from their customers via credit and debit cards.

    What is the big picture?

    • UPI has become the most inclusive mode of payment in India with over 26 crore unique users and five crore merchants on the platform.
    • The progress of UPI in recent years has been unparalleled.
    • Many other countries are engaged with us in adopting similar methods in their countries.
    • In May, UPI processed 5.95 billion transactions worth over Rs 10 trillion, a record high since its launch in 2016.
    • NPCI is looking to soon process a billion transactions a day.

     

    Try this PYQ from CSP 2017:

    Q.Which one of the following best describes the term “Merchant Discount Rate” sometimes seen in news?

     

    (a) The incentive given by a bank to a merchant for accepting payments through debit cards pertaining to that bank

    (b) The amount paid back by banks to their customers when they use debit cards for financial transactions for purchasing goods or services

    (c) The charge to a merchant by a bank for accepting payments from his customers through the bank’s debit cards

    (d) The incentive is given by the Government to merchants for promoting digital payments by their customers through Point of Sale (PoS) machines and debit cards

     

    [wpdiscuz-feedback id=”jap9mp9zh2″ question=”Please leave a feedback on this” opened=”1″]Post your answers here.[/wpdiscuz-feedback]

     

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  • Monetary tightening and its impact on growth

    Context

    A rate hike in the monetary policy committee’s June meeting was a foregone conclusion after the spike in inflation and an off-cycle surprise interest rate hike on May 4.

    Reasons fast forwarding of interest rate hike

    • 1] Broad based inflation: A confluence of factors has pushed inflation higher and made it persistent and broad-based. 
    • 2] Policy rates are still negative: Even with this hike, the repo rate, the signalling tool for bank interest rates, is still below pre-pandemic levels.
    • The real policy rate (repo rate less expected inflation) remains negative and has some distance to cover before it reaches positive territory — where the RBI would like to see it.
    • 3] Lag in effect: Monetary policy impacts growth, and thereafter, inflation with a lag.
    • To control inflation, the RBI needed to act faster by front loading rate hikes.
    • 4] Elevated inflation expectations: The risk of inflation expectations getting unmoored had risen.
    • Household and business inflation expectations remain elevated, as indicated by the RBI’s inflation expectations survey of households.
    • 5] Interest rate hike in the US: The aggressive stance of the US Federal Reserve and ensuing tightening financial conditions.
    • India is better placed today than in 2013 to face the Fed’s actions with a stronger forex shield.

    How US Fed’s actions affect India?

    • India is not insulated.
    • Capital outflow: The headwinds now are stronger than in 2013 and we have seen net capital outflows since October 2021.
    • S&P Global expects the US federal funds rate to be hiked to 3-3.25 per cent in 2023, higher than the pre-pandemic level, and highest since early 2008.
    • Despite a strong forex hoard, the RBI has had to deploy monetary policy to mute the impact of the Fed’s actions.

    Inflation and its impact

    • Upward pressure on food inflation: The pressure on food inflation has increased owing to the impact of the freak heatwave on wheat, tomatoes and mangoes, which is driving prices higher.
    • This is on top of rising input costs for agricultural production, the global surge in food prices and the expected sharper than usual rise in minimum support price.
    • Fuel inflation will remain high, duty cuts notwithstanding, as global crude prices remain volatile at elevated levels.
    • Core inflation, the barometer of demand, is a complex story.
    • Goods (despite only partial pass-through of input costs) are witnessing higher inflation than services.
    • That’s because services faced tighter restrictions during the Covid-19 waves, restricting their consumption and the pricing power of providers as well.
    • Service categories that are mostly regulated, such as public transport, railways, water and education, have over 50 per cent weight in core services.
    • However, prices of discretionary services such as airlines, cinema, lodging and other entertainment are rising.
    • Transportation-related services have seen the sharpest rise in the past six months due to fuel price increases.
    • Impact on the poor: For those at the bottom of the pyramid, high inflation hits harder because energy and food are a big chunk of their consumption basket.

    Growth prospects

    • S&P Global has recently cut the growth outlook for major economies for 2022 — that of the US to 2.4 per cent from 3.2 per cent, for Eurozone to 2.7 per cent from 3.3 per cent earlier, and for China to 4.2 per cent from 4.9 per cent.
    • This will hurt exports which are very sensitive to global demand.

    Monetary policy actions

    • Not all aspects of supply-driven inflation can be addressed via monetary policy.
    • So the authorities are complementing monetary policy actions by using the limited fiscal space to cut duties and extend subsidies to the vulnerable.

    Conclusion

    Monetary tightening impacts growth with a lag of at least 3-4 quarters and the fact that real interest rates are negative and borrowing rates still below pre-pandemic levels, implies monetary policy is unlikely to be growth-restrictive for this year.

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  • Challenges in global growth recovery

    Context

    The global economy was well on its path to recovery until the invasion of Ukraine by Russia.

    Uncertainties in global growth prospects

    • Divergent economic recoveries: Economic prospects have worsened since the Ukraine crisis, worsening the divergence between the economic recoveries of advanced economies and those of the developing ones.
    • The prevailing uncertainties in global growth prospects come in the aftermath of frequent disruptions to worldwide supply chains in the last two years.
    • Against this background, two key macroeconomic variables have a persistent effect on growth rebound.
    • 1] Price pressure: There is tenacious price pressure, leading to policy trade-offs especially in developing economies.
    • 2] Capital outflow: There have been capital outflows and a tightening of financial conditions, affecting investment and growth in the medium and long term.

    1] Price pressure

    • Global concern: In some of the advanced economies, inflation has reached its highest level in the last 40 years.
    • The major contributors to high inflation are energy and food prices.
    • A spike in oil and gas prices due to a tight fossil fuel supply and geopolitical uncertainty have led to substantial increases in energy costs worldwide.
    • In developing economies, rising food prices have had cascading effects, culminating in higher overall inflation.
    • This gets intensified if poor weather hits harvests and rising oil prices drive up the cost of producing and transporting fertilizers.
    • In developing economies, higher prices for food impacts different sections of the population differently, depending on the types of food consumed and the share of food expenditure in a household’s consumption basket.
    • Persistent short supply and increases in food and fuel prices could significantly increase the risk of social unrest as the poorer sections are pushed to the edge of heightened deprivation.

    2] Capital outflow

    • Emerging markets suffered their first portfolio outflows in a year in March 2022.
    • The Institute of International Finance (IIF) says “foreign net portfolio outflows for emerging markets came to $9.8 billion in March.
    • Investors have become more selective, as higher risk sensitivity mounts due to tighter monetary conditions and rising inflation.
    • Reasons for capital outflow: Interest rates tightening in the United States is associated with capital flow reversals from emerging markets.
    • Impact on developing economies: For developing economies, the result of sudden large capital outflows is currency depreciation and tighter external sector conditions, leading to growth fluctuations.

    Way forward

    • Monitor the pass-through of international prices: Though the factors contributing to high inflation (global supply shocks) are beyond the control of central banks, they need to carefully monitor the pass-through of rising international prices to domestic inflation to calibrate their responses.
    • Calibrate the pace of policy tightening: The pace of policy tightening needs to be attuned to prevailing economic situations and activity levels.
    • Communicate the importance of inflation targeting: Central banks could also signal a readiness to shift the monetary stance to maintain the credibility of their inflation-targeting frameworks by clearly communicating the importance of inflation stabilisation in their objectives and backing it with policy actions.
    • Foreign exchange interventions: As sudden capital flow reversals can threaten financial stability, foreign exchange interventions could address market imbalances.
    • Fiscal consolidation: There exists an imperative to prune expenditure and get back to the road of fiscal consolidation.
    • However, a push for consolidation should not prevent governments from prioritising spending to protect and help vulnerable populations affected by price increases and the pandemic.
    • Income support policies: In the post-pandemic global economy, there will be a likely cross-sectoral labour reallocation.
    •  These transitions require labour market and income support policies that are designed to provide safety nets for workers without hindering employment growth.

    Conclusion

    The message from the current phase of global growth is clear. Policymakers in the developing economies have to prepare for tighter financial conditions and spillovers from geopolitical volatility.

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  • What are Bad Banks?

    The finance ministry said the Rs 6,000-crore National Asset Reconstruction Company (NARCL) or bad bank is expected to take over the first set of non-performing accounts of banks next month.

    What is a Bad Bank?

    • A bad bank conveys the impression that it will function as a bank but has bad assets to start with.
    • Technically, it is an asset reconstruction company (ARC) or an asset management company that takes over the bad loans of commercial banks, manages them and finally recovers the money over a period of time.
    • Such a bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans.
    • The takeover of bad loans is normally below the book value of the loan and the bad bank tries to recover as much as possible subsequently.

    Bad Banks to be established

    • The NARCL-IDRCL structure is the new bad bank.
    • The National Asset Reconstruction Company Limited (NARCL) has already been incorporated under the Companies Act.
    • It will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases.
    • Another entity — India Debt Resolution Company Ltd (IDRCL), which has also been set up — will then try to sell the stressed assets in the market.

    How will the NARCL-IDRCL work?

    • The NARCL will first purchase bad loans from banks.
    • It will pay 15% of the agreed price in cash and the remaining 85% will be in the form of “Security Receipts”.
    • When the assets are sold, with the help of IDRCL, , the commercial banks will be paid back the rest.
    • If the bad bank is unable to sell the bad loan, or has to sell it at a loss, then the government guarantee will be invoked.
    • The difference between what the commercial bank was supposed to get and what the bad bank was able to raise will be paid from the Rs 30,600 crore that has been provided by the government.

    Will a bad bank resolve matters?

    • From the perspective of a commercial bank saddled with high NPA levels, it will help.
    • That’s because such a bank will get rid of all its toxic assets, which were eating up its profits, in one quick move.
    • When the recovery money is paid back, it will further improve the bank’s position.
    • Meanwhile, it can start lending again.

    Why do we need a bad bank?

    • The idea gained currency during Rajan’s tenure as RBI Governor.
    • The RBI had then initiated an asset quality review (AQR) of banks and found that several banks had suppressed or hidden bad loans to show a healthy balance sheet.
    • However, the idea remained on paper amid lack of consensus on the efficacy of such an institution.
    • ARCs have not made any impact in resolving bad loans due to many procedural issues.
    • While commercial banks resume lending, the so-called bad bank, or a bank of bad loans, would try to sell these “assets” in the market.

    Good about the bad banks

    • The problem of NPAs continues in the banking sector, especially among the weaker banks.
    • The bad bank concept is in some ways similar to an ARC but is funded by the government initially, with banks and other investors co-investing in due course.
    • The presence of the government is seen as a means to speed up the clean-up process.
    • Many other countries had set up institutional mechanisms such as the Troubled Asset Relief Programme (TARP) in the US to deal with a problem of stress in the financial system.

    Back2Basics: NARCL

    • NARCL has been incorporated under the Companies Act and has applied to Reserve Bank of India for license as an Asset Reconstruction Company (ARC).
    • NARCL has been set up by banks to aggregate and consolidate stressed assets for their subsequent resolution.
    • Public Sector Banks will maintain 51% ownership in NARCL.
    • The NARCL will acquire assets by making an offer to the lead bank.
    • Once NARCL’s offer is accepted, then, IDRCL will be engaged for management and value addition.

     

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