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GS Paper: Indian Economy

  • Taxing interest on Provident Fund

    Following its Budget announcement in February, the Finance Ministry has now notified the rules for taxing interest income on contributions made to the Employees’ Provident Fund (EPF) beyond Rs 2.5 lakh (for private-sector employees) and Rs 5 lakh (for government sector employees).

    What is Provident Fund?

    • Provident Fund is a government-managed retirement savings scheme for employees, who can contribute a part of their savings towards their pension fund, every month.
    • These monthly savings get accumulated every month and can be accessed as a lump sum amount at the time of retirement, or end of employment.
    • Since the provident fund money consists of a large chunk of savings, it can be used to grow your retirement corpus easily.

    Types of provident funds

    There are mainly three different types of PFs, which are as follows:

    1. General provident fund: It is a type of PF which is maintained by governmental bodies, including local authorities, the Railways, and other such bodies. Thus, these types of PFs are mainly defined by government bodies.
    2. Recognized provident fund: It is the one that applies to all privately-owned organizations that contain more than 20 employees. Moreover, holding a rightful claim to the PF associated with your organization, you will be given a UAN or Universal Account Number. This enables you to transfer your PF funds from one employer to another whenever you move from one occupation to another.
    3. Public provident fund: It is defined by the voluntary nature of investment on the part of the employee. The PPF is also associated with a minimum deposit of Rs. 50 and a maximum amount of Rs. 1.5 lakhs. The PPF has a lock-in period of 15 years.

    What is the tax on EPF contributions?

    • In February, the Budget proposed that tax exemption will not be available on interest income on PF contributions exceeding Rs 2.5 lakh in a year.
    • Although this has been a concern for salaried individuals contributing to EPF, it will impact only those who contribute more than Rs 2.5 lakh in a year.
    • It will not affect their existing corpus or the aggregate annual interest on that.
    • In March, the government proposed to double the cap on contribution from Rs 2.5 lakh to Rs 5 lakh for tax-exempt interest income where there is no contribution by the employer.
    • With this, the government provided relief for contributions made to the General Provident Fund that is available only to government employees and there is no contribution by the employer.

    Why tax the PF?

    • There have been instances where some employees are contributing huge amounts to these funds and are getting the benefit of tax exemption at all stages — contribution, interest accumulation, and withdrawal.
    • With an aim to exclude high net-worth individuals (HNIs) from the benefit of high tax-free interest income on their large contributions, the government has proposed to impose a threshold limit for tax exemption.
    • This will be applicable for all contributions beginning April 1, 2021.

    How will it get taxed?

    • For an individual in the higher tax bracket of 30%, the interest income on contribution above Rs 2.5 lakh would get taxed at the same marginal tax rate.
    • What this means is that if an individual contributes Rs 3 lakh every year to the provident fund (including the voluntary PF contribution) then the interest on his contribution above Rs 2.5 lakh —that is, Rs 50,000 — will be taxed.
    • So, the interest income of Rs 4,250 (8.5% on Rs 50,000) will be taxed at the marginal rate. If the individual falls in the 30% tax bracket, he/ she will have to pay a tax of Rs 1,325.
    • For an individual contributing Rs 12 lakh in a year, the tax will be applicable on interest income on Rs 9.5 lakh (Rs 12 lakh minus Rs 2.5 lakh). In this case, the tax liability would amount to Rs 25,200.

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  • Our banks are mispricing capital

    Context

    We have a situation in India today where the policy repo rate has been kept low. Banks are just about managing their non-performing assets (NPAs) and there is uncertainty in the air.

    Mispricing of capital by banks

    • There are different components of the cost of funds for banks, which are captured by the MCLR or marginal cost of funds-based lending rate.
    • For every ₹100 deposits that enter the banking system, there are different accompanying costs for the system.
    • These are deposit costs, provisioning for NPAs, return on assets (ROA or minimum profit), and the regulatory cost of cash reserve and statutory liquidity ratio balances (CRR and SLR) that perforce have to be held.
    • Adding these components, the basic cost works out to be 8.9%, which should be the rate at which incremental lending should take place.
    • By offering loans at a much lower rate of 7.23%, the system is actually mispricing capital.
    • It may be noted that deposit rates have been compressed to a very large degree and so this cost of 4% is very low.
    • Banks do have the advantage of getting free demand deposits and the right to offer differential rates on saving accounts.
    • Clearly, deposit-holders are subsidizing borrowers quite significantly.

    Issue of NPA provisioning in India

    • In the past couple of years, provisions as a proportion of NPAs have averaged 30-40%.
    • As NPAs increase, ideally, banks should load this cost onto their borrowers.
    • But that rarely happens in India. Instead, it is taken on banks’ books and gets reflected in their balance sheets.
    • If NPAs were kept in the region of, say, 4-5% of assets, it would have been possible to bring the cost down to 1.5% (from 3%), which would then have justified the present MCLR.

    Low return on assets (ROA)

    • The ideal return norm is 1%, which should be derived from all assets.
    • This does not happen for banks’ investment portfolios, and the value imputed here is only for loans.
    • The ROA for banks is abysmally low, as this aspect does not go into the pricing of products on the asset side.
    • Deposit costs have been driven down as savers don’t have a choice.
    • But a commensurate return does not materialize in the loan books of banks.

    Cost of regulations

    • The CRR component gets no compensation, while the SLR part earns around 6%, which is the average cost of fresh borrowing for the Union government.
    • While these numbers vary across banks, the minimum rate of 8.9% would hold for the system, which will vary by the level of NPAs.
    • The concept of linking benchmarks to certain loans further misprices fresh lending, as those loans are not ideal anchors to use, for they are being manually driven downwards by a deluge of liquidity in the system after the pandemic.
    • Excess liquidity of ₹4-7 trillion a day since April 2020 has meant banks have been placing funds costing them 8.9% with the central bank which gives them just 3.35%.
    • This is eventually borne by bank shareholders.

    Implications

    • With rather rigid policies on corporate lending to avert possible NPAs, banks have preferred lending to the retail segment, which is less risky, and small businesses, backed by the Centre’s credit guarantee.
    • The central bank’s government-bond buying programme to provide liquidity has been successful.
    • But in the absence of fructification of lending and a continuous rollover of funds at the reverse-repo window, Indian banks are bearing a negative carry trade, with a 6% return traded for just 3.35%.

    Conclusion

    Banks must price capital appropriately and not get overly influenced by arguments in favor of cheap credit or the fact that loans are cheaper in the West. We need to get practical on this issue.

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    Back2Basics: CRR and SLR

    • Cash Reserve Ratio, or popularly known as CRR is a compulsory reserve that must be maintained with the Reserve Bank of India.
    • Every bank is required to maintain a specific percentage of their net demand and time liabilities as cash balance with the RBI.
    •  The banks are not allowed to use that money, kept with RBI, for economic and commercial purposes.
    • It is a tool used by the apex bank to regulate the liquidity in the economy and control the flow of money in the country.
    • Statutory Liquidity Ratio, shortly called as SLR also an obligatory reserve to be kept by the banks, as prescribed securities, based on a certain percentage of net demand and time liabilities.
    •  It is used to maintain the stability of banks by limiting the credit facility offered to its customers.
    • CRR is maintained in the form of cash while the SLR is to be maintained in the form of gold, cash, and government-approved securities.

  • Gauging household income key for microfinance clients

    Context

    The Reserve Bank of India’s (RBI) recently released a Consultative Document on Regulation of Microfinance in June 2021.

    Consultative document makes household income a critical variable

    • Following the Malegam Committee Report, which is a decade old now, the current document looks to reassess and realign the priorities of the sector.
    • Some of the key regulatory changes proposed in the document take household income as a critical variable for loan assessment
    • Definition of microfinance: The definition of microfinance itself is proposed to mean collateral-free loans to households with annual household incomes of up to ₹1,25,000 and ₹2,00,000 for rural and urban areas respectively.
    • Household income assessment: The document requires all Regulated Entities to have a board-approved policy for household income assessment.
    • Cap on repayment: It caps loan repayment (principal and interest) for all outstanding loans of the household at 50% of household income.
    • Therefore, measuring household income accurately becomes critical for the effective implementation of these norms.

    Challenges in measuring the income of Low-Income-Household (LIH)

    • Seasonal and volatile: Low-Income Households (LIHs), who typically form the customer base for Microfinance Institutions (MFIs), often also have seasonal and volatile income flows. 
    • Measuring expenditure doesn’t reflect their income: Since income for LIHs is seasonal and volatile, there have been attempts to understand their inflows by measuring their expenditure.
    • But, given the rotational debts they avail to fund a consumption expenditure here and a loan repayment obligation there, expenditure also does not truly reflect the household’s income.
    • Not separate personal expenditure: Moreover, for most LIHs, their expenditure on income-related activity is not separate from their personal expenses.
    • Therefore, it is difficult to separate the household’s personal expenses from that of their occupational pursuits.
    • Given these complexities, we need to understand and accept that for the bulk of LIHs, household finance is not just personal family finance, but their business finance as well.

    3 ways to measure household income for microfinance client

    • Structured survey approach: A structured survey-based approach could be used by Financial Service Providers (FSPs) to assess a household’s expenses, debt position and income from various sources of occupation and seasonality of income.
    • Template-based approach: A template-based approach could be used wherein FSPs could create various templates for different categories of households (as per location, occupation type, family characteristics, etc.).
    • These templates could then be used to gauge the household income of a client matching a particular template.
    • Centralised database: FSPs could also form a consortium to collect and maintain household income data through a centralised database.
    • This would allow for uniformity in data collection across all FSPs and, over time, can be used to validate the credibility of any new client’s reported income.
    • Such a database would also enable FSPs to track the changes in household income over time.

    Way forward

    • Use technology: Finding cost-effective yet accurate ways of capturing this information becomes crucial.
    • Creating new technology to document and analyze cash flows of LIHs would not only facilitate credit underwriting but also innovation in the standard microcredit contracts through customized repayment schedules and risk-based pricing, depending on a household’s cash flows.

    Conclusion

    Eventually, an accurate assessment of household-level incomes would avoid instances of over-indebtedness and ensure the long-term stability of the ecosystem.

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  • The National Monetisation Pipeline may not help realise the best value for assets

    Context

    The Government has launched a National Monetisation Pipeline, or NMP  to sell the revenue streams of public assets over the next four years.

    About NMP

    • Financing infrastructure: As outlined in the Union Budget, the NMP aims to mobilize resources for financing infrastructure.
    • Type of assets: The pipeline mostly includes railway stations, freight corridors, airports, and renovated national highway segments amounting to ₹6-lakh crore, or 3% of GDP in 2020-21.
    • The other two methods of raising resources are: setting up a development finance institution (DFI) and raising the share of infrastructure investment in the central and State Budgets.

    Concerns

    1) Not different from Disinvestment-Privatisation (D-P)

    • Asset monetization as defined in NMP is the same as the net present value (NPV) of the future stream of revenue with an implicit interest rate (whether it is a sale or lease of the asset).
    • Missed targets: Since D-P proceeds (revenues) have seriously missed the targets almost every year, how believable are the NMP targets? And how are they likely to perform differently?
    • If the NMP attempt to shore up public finances, such distress (fire) sale would find it difficult to obtain a “fair value” for public assets.
    • Would the market not factor in the dire state of the economy in beating down the prices, as in any distress sale?
    • The NMP document seems silent on how to overcome past mistakes.

    2) PPP mode of implementation

    • The NMP outlines mainly two modes of implementing monetization: public-private partnership (PPP) and “structured financing” to tap the stock market.
    • PPP in infrastructure has been a financial disaster in India, as evident from what happened after the economic boom of 2003-08.
    • After the 2008 financial crisis, many PPP projects failed to repay bank loans leading to the piling up of non-performing assets (NPAs) of banks.
    • Further, the bulk of the lending was too politically connected to corporate houses and firms.
    •  India is still reeling from the legacy of that period without any easy and credible solutions in sight.

    3) Stock market crash threatens the success of InvIT

    • An Infrastructure Investment Trust (InvIT) is being mooted as an alternative means of raising finance from the stock market.
    • In principle, InvIT is much like a mutual fund, whose performance is largely linked to stock prices.
    • The disinvestment process began in 1991 in which the bundles of shares of public sector enterprises (PSEs) were sold by UTI in the booming secondary stock market to realize the best price.
    • However, as the market crashed in the wake of the Harshad Mehta scam, stalling and discrediting the disinvestment process for almost the entire decade.
    • Hence, it may be worth learning the lessons from the historical missteps before exploring the idea all over again by the current stock market boom
    • At present, the U.S. Fed committed to reducing its assets purchase program (known as quantitative easing), the “hot money” inflow that has fuelled Indian stock prices may dry up throwing up nasty surprises.

    Thus, it seems unwise to anchor the acutely needed investment revival strategy on a discredited PPP model or on fickle Foreign Institutional Investors (FII) investment in a frothy stock market.

    Suggestion: Monetise debt

    • With the financial system flush with liquidity with no takers for bank credit, finance the proposed investment — as envisaged in the Budget — by government borrowing.
    • With a negative 0.4% real interest rate (real interest rate is nominal interest rate minus inflation rate), domestic borrowing in home currency is a steal.
    • No Crowding out: Chances of crowding-out private investments are remote with a liquidity overhang in the market.
    • Low inflation risk: Inflation risk is also limited with little aggregate demand pressures (barring temporary bottlenecks due to localized lockdowns).
    • Rating downgrade risk:  If the debt is productively used to expand GDP (the denominator), rating downgrade risk due to the rising Debt-GDP ratio seems minimal.
    •  Moreover, rising external debt by fickle portfolio investors perhaps carries a greater risk to external instability.

    Consider the question “How the National Monetisation Pipeline seeks to implement the asset monetisation? What are the challenges in asset monetisation?”

    Conclusion

    If reviving investment demand quickly is the real goal, debt monetisation seems a better option than asset monetisation.

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  • India becomes 4th largest forex reserves holder globally

    India’s foreign exchange reserves rose by $835 million to touch a record high of $612.73 billion in the week ended July 16, 2021, the Reserve Bank of India (RBI) data showed.

    Forex Reserves

    India’s forex reserves cover:

    • Foreign Currency Assets (FCAs) (rose by $463 million to $568.748 billion)
    • Special Drawing Rights (SDRs) (up by $1 million at $1.548 billion)
    • Gold Reserves (up by $377 million to $37.333 billion)
    • Reserve position with the International Monetary Fund (IMF) (up by $1 million at $1.548 billion)

    (Note the descending order of the shares of various components of forex reserves. UPSC can go factual here.)

    What is Foreign Exchange Reserve?

    • Foreign exchange reserves are important assets held by the central bank in foreign currencies as reserves.
    • They are commonly used to support the exchange rate and set monetary policy.
    • In India’s case, foreign reserves include Gold, Dollars, and the IMF’s quota for Special Drawing Rights.
    • Most of the reserves are usually held in US dollars, given the currency’s importance in the international financial and trading system.
    • Some central banks keep reserves in Euros, British pounds, Japanese yen, or Chinese yuan, in addition to their US dollar reserves.

    Countries with the highest foreign reserves

    Currently, China has the largest reserves followed by Japan and Switzerland. India has overtaken Russia to become the fourth largest country with foreign exchange reserves.

    1. China – $3,349 Billion
    2. Japan – $1,376 Billion
    3. Switzerland – $1,074 Billion
    4. India – $612.73 Billion
    5. Russia – $597.40 Billion

    Why are these reserves so important?

    • All international transactions are settled in US dollars and, therefore, required to support India’s imports.
    • More importantly, they need to maintain support and confidence for central bank action, whether monetary policy action or any exchange rate intervention to support the domestic currency.
    • It also helps to limit any vulnerability due to sudden disturbances in foreign capital flows, which may arise during a crisis.
    • Holding liquid foreign currency provides a cushion against such effects and provides confidence that there will still be enough foreign exchange to help the country with crucial imports in case of external shocks.

    Initiatives taken by the government to increase forex

    • To increase the foreign exchange reserves, the Government of India has taken many initiatives like AatmaNirbhar Bharat, in which India has to be made a self-reliant nation so that India does not have to import things that India can produce.
    • Other than AatmaNirbhar Bharat, the government has started schemes like Duty Exemption Scheme, Remission of Duty or Taxes on Export Product (RoDTEP), Nirvik (Niryat Rin Vikas Yojana) scheme, etc.
    • Apart from these schemes, India is one of the top countries that attracted the highest amount of Foreign Direct Investment, thereby improving India’s foreign exchange reserves.

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  • Asset monetisation — execution is the key

    Context

    The government has announced an ambitious programme of asset monetisation. It hopes to earn ₹6 trillion in revenues over a four-year period.

    About Asset monetisation

    • Unlike in privatisation, no sale of government assets is involved.
    • The government parts with its assets — such as roads, coal mines — for a specified period of time in exchange for a lump sum payment.
    • Asset monetisation will happen mainly in three sectors: roads, railways and power.
    • Other assets to be monetised include: airports, ports, telecom, stadiums and power transmission.
    • Two important statements have been made about the asset monetisation programme.
    • The focus will be on under-utilised assets.
    • Monetisation will happen through public-private partnerships (PPP) and Investment Trusts.

    Challenges

    1) Investors would prefer property utilised assets over underutilised assets

    • Suppose an asset is not being used adequately because it has not been properly developed or marketed well enough.
    • A private party may judge that it can put the assets to better use.
    • It will pay the government a price equal to the present value of cash flows at the current level of utilisation.
    • This is a win-win situation for the government and the private player.
    • The government gets a ‘fair’ value for its assets.
    • The private player gets its return on investment.
    • Increase in efficiency: The economy benefits from an increase in efficiency.
    • Monetising under-utilised assets thus has much to commend it.
    • However, in case of an asset that is being properly utilised, the private player has little incentive to invest and improve efficiency.
    • It simply needs to operate the assets as they are.
    • The private player may value the cash flows assuming a normal rate of growth.
    •  The cost of capital for a private player is higher than for a public authority.
    • The higher cost of capital for the private player could offset the benefit of any reduction in operating costs.
    • The government earns badly needed revenues but these could be less than what it might earn if it continued to operate the assets itself.
    • There is no improvement in efficiency.
    • The benefits to the economy are likely to be greater where under-utilised assets are monetised.
    • However, private players will prefer well-utilised assets to assets that are under-utilised.
    • That is because, in the former, cash flows and returns are more certain.

    2) Valuation challenges

    • It is very difficult to get the valuation right over a long-term horizon, say, 30 years.
    •  For a road or highway, growth in traffic would also depend on factors other than the growth of the economy.
    • . If the rate of growth of traffic turns out to be higher than assessed by the government in valuing the asset, the private operator will reap windfall gains.
    • Alternatively, if the winning bidder pays what turns out to be a steep price for the asset, it will raise the toll price steeply.
    • The consumer ends up bearing the cost.
    • It could be argued that a competitive auction process will address these issues and fetch the government the right price while yielding efficiency gains.
    • But that assumes, among other things, that there will be a large number of bidders for the many assets that will be monetised.

    3) Life of the returned asset may not be long

    • There is no incentive for the private player to invest in the asset towards the end of the tenure of monetisation.
    • The life of the asset, when it is returned to the government, may not be long.
    • In that event, asset monetisation virtually amounts to sale.
    • Monetisation through the PPP route is thus fraught with problems.

    Way forward: InvIT route

    • Infrastructure Investment Trusts (InvIT) are mutual fund-like vehicles in which investors can subscribe to units that give dividends.
    •  Monetisable assets will be transferred to InvITs.
    • The sponsor of the Trust is required to hold a minimum prescribed proportion of the total units issued.
    • InvITs offer a portfolio of assets, so investors get the benefit of diversification.
    • In the InvIT route to monetisation, the public authority continues to own the rights to a significant portion of the cash flows and to operate the assets.
    • So, the issues that arise with transfer of assets to a private party — such as incorrect valuation or an increase in price to the consumer — are less of a problem.

    Key takeaways

    • Low cost of capital for public authority: In general, due to the low cost of capital for public authority, the economy is best served when public authorities develop infrastructure and monetise these.
    • InvIT route: Monetisation through InvITs is likely to prove less of a problem than the PPP route.
    • Monetise under utilised assets: We are better off monetising under-utilised assets than assets that are well utilised.
    • Monitoring authority should be set up: To ensure proper execution, there is a case for independent monitoring of the process.
    • The government may set up an Asset Monetisation Monitoring Authority staffed by competent professionals.

    Consider the question “How asset monetisation is different from privatisation? What are the challenges in asset monetisation? Suggest the ways forward.”

    Conclusion

    Government must pay attention to the challenges in asset monetisation and use it in the proper way to increase the efficiency in the economy.

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  • How to read the state of the economy

    Context

    GDP growth estimates range from a high of 11 per cent, as per the government, to 9.5 per cent as per RBI. The variation is stark. So, what should one look at to evaluate the state of the economy?

    Things to consider while evaluating the economy

    • First, since the economy contracted by 7.3 per cent in 2020-21, all numbers will be exaggerated in the upward direction.
    • Second, beware of interpretations based on single-month data.
    • Cumulative numbers are better at times, but can be misleading too.
    • Third, what is more important is how things will play out during September-December as this is the festival-cum-harvest season which engenders spending normally.
    • Several indicators are used as leading signals of the economy, but here, too, we need to be careful.
    • PMIs for manufacturing and services tell us if we are better off than the previous month.
    • But that is not how data is normally presented as we usually talk of year-on-year growth.
    • But it is an early signal for sure. The IIP and core sector numbers will be influenced by base numbers and come with a lag.

    Indicators to look at as signs of recovery

    • Credit growth: Bank credit is a good indicator of whether companies are producing more as all activity requires working capital.
    • Here, the picture is not good as growth is (-) 0.4 per cent as of July end, indicating that activity has not picked up yet.
    •  Therefore, credit growth is in the negative territory.
    • Investment:  Debt issuances are lower in the first four months at around Rs 1.25 lakh crore, which is half of the Rs 2.57 lakh crore mobilised last year.
    • Therefore, the investment scenario is still one where companies are watchful.
    • There is surplus capacity in industry with utilisation rate being at 69.4 per cent in March 2021.
    • Rural demand: Rural demand is an integral part of the story and presently progress on the kharif crop is satisfactory.
    • A good crop is also necessary to generate spending power besides augmenting supplies in the market as well as food processing industry.
    • The second wave has pushed back rural households with more expenditure on health care.
    • Employment generation: Employment generation is a trigger for higher income and spending and while the battle between CMIE and EPFO data remains unresolved, the market will finally reveal if people have more money.

    Inflation concern

    • Inflation is high and though there is a view that it is transient.
    • Several households, who are living on a fixed income have witnessed a double whammy in the form of lower returns on deposits and cumulative inflation of 6 per cent last year, and a similar number this year.

    Conclusion

    Investment will trail consumption and while the Centre has a good capex plan, it is only one piece in the overall puzzle. The private sector must get involved and with the banks being hesitant, the road can get longer.

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  • A way of diluting credit discipline

    Context

    Some bank borrowers have gone to court demanding that it quash the Reserve Bank of India (RBI) circular dated August 6, 2020 on opening current accounts.

    Background

    • Current accounts with non-lending banks are an important channel for diversion.
    • Diversion of funds is a major reason for large non-performing assets (NPAs).
    • Internal diversion is for non-priority purposes and funds can also be diverted to other firms, owned or controlled by the same group, friends or relatives.
    • To prevent this, the RBI mandates a No-Objection Certificate (NOC) from lending banks before opening such accounts.
    • Banks should verify with CRILC, the RBI credit database, and inform lenders. Banks should also obtain a NOC from the drawee bank when an account is opened through cheques.
    • Widespread non-compliance with mandated safeguards forced the RBI to bar non-lending banks from opening current accounts for large borrowers.
    • Thus, if borrowing is through a cash credit or overdraft account, no bank can open a current account.

    What are the current regulations?

    • If a borrower has no cash credit or overdraft account, a current account can be opened subject to restrictions.
    • If the bank’s exposure is less than 10% of total borrowings, debits to the account can only be for transfers to accounts with a designated bank.
    • If total borrowing is ₹50 crore or more, there should be an escrow mechanism managed by one bank which alone can open a current account.
    • Other lending banks can open ‘collection accounts’ from which funds will be periodically transferred to the escrow account.
    • If the borrowing is between ₹5 crore and ₹50 crore, lending banks can open current accounts.
    • Non-lending banks can open collection accounts.
    • If borrowing is below ₹5 crore, even non-lending banks can open current accounts.
    • The working capital credit should be bifurcated into loan and cash credit components at individual bank levels.

    Issues with regulations

    • If a borrower has an overdraft, how can there not be a current account?
    • An overdraft is the right to overdraw in a current account up to a limit.
    • The second issue is that the circular forecloses such operational flexibility.
    • Third, why should a bank with low exposure transfer funds to another bank when it can use it to adjust other dues with it?
    • Fourth, share in borrowing is not static. Crossing the threshold both ways could happen often.
    • Fifth, there is a mismatch between what a borrower needs and the regulations allow.
    • Support of non-lending banks through current accounts in other banks is required for large accounts.
    • Sixth, transactions in an active current account enables a bank to monitor a borrower’s account, however small.
    • The lack of such control was why large development financial institutions of yesteryear built up huge NPAs.
    • Seventh, the regulation mandates splitting working capital into loan and cash credit components across all banks.
    • Such a one-size-fits-all regulation does not factor in the purpose of the different facilities.
    • A large company might avail itself of loans in Mumbai, but require current accounts with another bank in Assam where it might have a factory.
    • Lack of flexibility: Rules are not flexible, do not provide for unforeseen circumstances, and can be easily circumvented.
    • Use more generic terms: Regulation needs to use more generic terms. Terms such as Working Capital Term Loan might mean different things in different banks.
    • Diversion of fund is risk better dealt by banks: Is it not better to leave management of exceptional risks such as diversion of funds to the banks?
    • The cost of regulation: the costs of regulation be justified by the benefits.

    Conclusion

    When regulation ignores market practices, it lacks legitimacy, a construct from neo-institutionalist literature. When legitimacy is wanting, compliance suffers.

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  • Account aggregators

    Context

    Account Aggregators will enable the use and enrich the quality of information needed for lenders to extend loans without collateral back-up.

    Issue of preference for a collateralised loan in India

    • Demand for credit in India far outstrips institutional supply.
    • Financial Service Providers (FSPs) are well aware of this demand.
    • And they have been looking for ways to provide credit without collateral back-up.
    • Historically, financial service providers (FSPs) like banks and non-bank finance companies (NBFCs) have relied on collateral while making lending decisions.
    • In the absence of collateral pledges, the only way to assess a consumer’s willingness and ability to repay is by examining the prospective borrower’s cash flows.
    • Your bank account statement is a digital representation of your financial life.
    • However, this bank account statement-driven process is highly manual, time-consuming, expensive and fraught with potential for abuse.
    • These shortcomings have held back cash-flow based lending for too long in India.
    •  Borrowers in the country have been underserved because of the preference for collateralized loans.
    • Both FSPs and consumers are in dire need of a seamless digital way of sharing account information.

    Account Aggregator (AA) framework

    • The account aggregator framework announced by the Reserve Bank of India (RBI) promises to solve these problems.
    • It aims to make financial data sharing as easy as making a Unified Payments Interface (UPI) transfer.
    • This is the promise of account aggregation, as envisaged by RBI.
    • Account aggregators (AAs), with their user interface, will play a pivotal role in closing the trust deficit between FSPs and consumers.

    Fenefits of Account Aggregator would work

    • User control over data: They permit users to control who gets access to their data, track and log its movement and reduce the potential risk of leakage in transit.
    • A single-window format allows user-friendly data movement and reduces the need for physical transfers and post-facto attestations.
    • Industry-standard for consent: AAs create a default industry standard for consent that cuts through the dense fine print buried in most privacy policies.
    • Wider data points to rely on: With the security of this data as a given, AAs allow lenders (or other FSPs for that matter) to rely on a wider selection of data points to determine the trustworthiness of a borrower.
    • Through AAs, FSPs have a chance to provide cash-flow based credit, personalized financial management tools, robo-advisory services and many more innovative financial products and services to a wider cross-section of people.

    Conclusion

    By incorporating security, transparency and agility into data sharing, AAs could usher in the most significant transformation of India’s fintech landscape yet.

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  • Indian bond trading is in need of better market making

    Context

    The Indian market for corporate debt needs buoyancy and this has been high on the agenda of our regulator

    Background

    • The Reserve Bank of India (RBI) stopped the automatic monetization of the fiscal deficit in 1997 and made the government borrow money from the market.
    • There are primary dealers or PDs, who pick up the Centre’s bond and provide buy and sell quotes in the secondary market for government bonds and thus help ensure sufficient liquidity.
    • The PDs came to be known as market makers and are paid a commission for playing that role.

    Liquidity challenge in the corporate bond market

    • Unlike the market for government bonds,  in the case of the country’s corporate bond market, the challenge is different.
    • It’s typically remunerative for a buyer to buy a security and hold on to it till its maturity.
    • Therefore, insurance companies, provident funds, and pension funds hold such long-term paper, as they can match the tenure of their assets with liabilities.
    • But this does not add liquidity to the market, and anyone buying a corporate bond today may not find someone to sell it to tomorrow as this market has little trading depth.
    •  Even in the G-Sec market, where we assume plenty of liquidity, it is a thinly-traded market, even though the perception is that it is very liquid.

    Why do we need market makers for the corporate bond market

    • To deal with the lack of depth and liquidity in the corporate debt market, the Securities and Exchange Board of India’s (Sebi) idea of creating market makers holds immense significance.
    • The fundamental problem here is that a bond is different from a share.
    • A company’s share can be exchanged seamlessly because every share in the market is the same slice of ownership.
    • Lack of quotes for different bonds of different tenure: In the case of bonds, however, there are several issuances of a company.
    • A single financial institution or non-bank financial company could have as many as 10 issuances a year of varying maturities and interest rates, making each of them a unique instrument.
    • Company XYZ may have issued in October 2015 a bond with a face value of ₹100 that pays 6% interest and is due for redemption in 2030, which will be quoted on exchanges for trading (if it’s being traded).
    • But, in 2021, it is no longer a 15-year bond, but a 9-year paper.
    • Therefore, the security loses importance, as the market normally uses benchmarks like 5 or 10 or 15 years; and every bond drops in the pecking order once it crosses these thresholds.
    • Therefore, we need to have market makers who will offer quotes for all major securities and thereby ensure that critical bonds are still available for trading.

    Suggestions

    • Provide waivers: Playing market maker will involve a cost and hence there should be certain waivers provided to them on trading fees.
    • Preferential access: They can be given preferential access to new issuances, so as to build up an inventory.
    • Waiver of mark-to-market: The mark-to-market (MTM) rules could be waived for a specified period, as valuation differences can affect their profit and loss accounts.
    • Capital at lower cost: Capital can be made available at a lower cost to market makers, as they require funding for the same.
    • Fifth, trade among market makers can be awarded benefits in terms of fees or easier taxes on gains made.
    • Create bond index: We need to have tradable-bond indices that reflect the price movements of a basket of bonds that they track.
    • Made public, such indices will provide appropriate arbitrage opportunities for investors to come in, and this should generate liquidity in the market for these bonds.

    Consider the question “Why bond market in India lacks the depth as compared to equity markets. What are the factors responsible for this? Suggest the way forward.”

    Conclusion

    Market makers are a way out. While success cannot be guaranteed, the idea should be adopted nonetheless, as with credit default swaps. It’s a work-in-progress. Let’s speed it up.

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    Back2Basics: Automatic monetization of deficit

    • The monetization of deficit was in practice in India till 1997, whereby the central bank automatically monetized government deficit through the issuance of ad-hoc treasury bills.
    • Two agreements were signed between the government and RBI in 1994 and 1997 to completely phase out funding through ad-hoc treasury bills.
    • And later on, with the enactment of the FRBM Act, 2003, RBI was completely barred from subscribing to the primary issuances of the government from April 1, 2006.