A co-authored article in Business Line on the upcoming May 3rd annual monetary policy review by the RBI

http://www.thehindubusinessline.com/todays-paper/tp-opinion/more-to-policy-than-rate-cut/article4677933.ece

Taxing the super-rich in India – avoid unintended consequences

          In 2012, Joseph Stiglitz, 2001 Nobel Laureate, one of the world’s foremost thinkers in contemporary economics, author of the 2012 best-seller titled “The Price of Inequality” was quoted in the New York Times as saying “…..Inequality leads to lower growth and less efficiency. Lack of opportunity means that it’s most valuable asset — its people — is not being fully used. Many at the bottom, or even in the middle, are not living up to their potential, because the rich, needing few public services and worried that a strong government might redistribute income, use their political influence to cut taxes and curtail government spending. This leads to underinvestment in infrastructure, education and technology, impeding the engines of growth. . .” He may have been commenting on the state of play in the United States but the words ring true in the context of several economies world-wide including India.

          Let’s look at some recently published statistics that highlight the extent of inequality in the Mecca of global Capitalism – the United States. A 2012 US census bureau population report places the average income of the top 2% of American households in 2011 at US $ 0.42 million which is approximately 30 times that of the bottom 30%. In fact, on a purchasing power parity basis, the average household income at the bottom 15% of the US pyramid is lower than the per capita income of Namibia, Algeria or Guyana! An analysis of growth in real post tax income over the last 3 decades since 1979, indicates that at the peak of the financial boom in 2007 (just before the markets collapsed), the top 1% of households in America had grown their incomes 300% while the bottom 20% could only manage a tenth of that growth (see figure: Source – Centre on Budget and Policy Priorities) – possibly underlining the ‘rent-seeking’ behaviour of those with influence. What else could likely explain prolonged periods of favourable tax rates for high income groups and a comfortably high exemption limit estate tax structure that effectively only taxes super-rich couples on estate valued over US $ 10 million after their lifetime?

Much has been written in the US press about the rapidly widening gap between the ‘haves’ and the ‘have-nots’ since the emergence of the global financial crisis. Kenneth Rogoff, professor of economics at Harvard recently commented, rather sombrely, that modern capitalism is in a state of evolution and that while alternatives to modern capitalism do not appear readily available.......... ‘Capitalism’s future might not seem so secure in a few decades as it seems now.’ In particular, he identifies key fault lines that capitalism must address to avoid a descent into oblivion: (1) failing to price public goods properly – like clean air, water or a stable climate; (2) inequality; (3) failure to price and provide efficiently for medical care; (4) failing to value the wellbeing of future generations, including through resource depletion; and (5) financial crises.

          Considerable talk about increasing the impact of tax on the “super-rich” has already occupied centre-stage – over the last couple of years in the West and more recently in India. Greater need for participation in the fiscal fortunes of their countries, reducing the likelihood of social instability thereby preserving a conducive climate for long term investment and, quite simply, philanthropic motivations have been put forth as arguments for greater tax contribution by the top income groups.  One key driver for the low impact of tax as a percentage of total income for the very rich, especially in the US is due to increased ‘financialisation’ of income streams. In 2010, the Inland Revenue Service (American equivalent of India’s Income Tax Department), estimated that the share of capital gains and equity dividends in total reported income of tax-payers earning more than US $ 10 million was 49% (up from 36% in 2009). These sources of income are taxed at very low or zero rates. As a result, overall contribution by this segment to the tax kitty is significantly muted, leading Warren Buffet to comment last year that his secretary’s effective tax rate was substantially higher than his own.

Since November 2012, reports have periodically surfaced in the Indian media, indicating a re-think by the Government on the peak income tax rates, additional levies for the “very rich” and even, introduction of an estate or inheritance tax. The Union Budget is about three weeks away and therefore, the rhetoric appears to be building up. It appears that some of the current re-think may be attributable to the debate in the West around reducing inequality through increased taxation at the top level. While there can be no question as to the desirability of redistributing incomes in a country like India, we must neither ignore the unintended consequences of such a levy nor forget that the Indian economy is direly in need of productive capital. India is not the United States and a note of caution is in order. It’s easy to forget that our legal and enforcement systems are British by design, not by implementation. The likely behavioural consequences of a high top rate of tax are increased efforts at tax evasion, postponement of investment decisions, dummy (benami) holdings, cross-border location of assets / investments and channelling wealth into opaque, non-productive resources such as gold and real estate. There is also interesting research undertaken by the National Bureau Of Economic Research (NBER) in the US context that higher tax rates discourage entrepreneurship and the growth of small firms as entrepreneurs begin to drop productive efforts in view of diminishing returns (due to diminishing marginal benefits). This would indeed be a dismal outcome for a growing economy like India which is desperately in need of entrepreneurship capital and is currently witnessing a stifling shortage of funds to the SME sector. Instead of levying higher taxes, it may be a better idea to consider incentives that would encourage capital owners to shift resources to productive avenues and unleash capital flow to fund starved sectors. That could alter the growth dynamic in the macroeconomic equation and better help plug the fiscal deficit in the medium term. It goes without saying that all this needs to be balanced with a strong tone and strident execution on enhanced tax enforcement and compliance with existing laws. In about three weeks we will know if better sense has prevailed.

This article was first published in www.marketexpress.in on Feb 6th, 2013

The RBI Balance Sheet – a delicate balancing act

Background

The annual report of the Reserve Bank of India for financial year 2011-12 was recently published and is available in the public domain for analysis. Central Bank balance sheets have been under enormous scrutiny since the commencement of the global slow-down in 2008, ever since massive accommodation by governments meant the transfer of systemic risk from the financial sector to the government sector. This is not surprising given that data available in the annual reports reflect in varying degrees, the extent of monetary expansion undertaken, the severity of domestic liquidity constraints and scale of central bank accommodation provided to the government sector.

Significant uptick in acquisition of domestic securities

As at June 30, 2012, cumulative assets on the RBI balance sheet aggregated INR 22 trillion – at current market prices this is nearly 25% of India’s estimated GDP, while at factor cost it amounts to 42% for financial year 2011-12. Total balance sheet expansion during the financial year was of the order of INR 4 trillion - driven by two broad themes. First, “demand-driven” factors have resulted in an increase in currency circulation of INR 1.4 trillion (14% increase YOY). In the seven years to June 2012, money in circulation has nearly trebled, pointing to the degree of monetary expansion undertaken. The offset to monetary expansion is visible on the RBI balance sheet where holdings of Government of India (GOI) securities have expanded over INR 1.9 trillion during 2011-12. Obviously, part of this expansion reflects holding gains, given benchmark yield rates have edged lower during 2011-12. The RBI is estimated to have bought net securities to the tune of INR 1.3 trillion during 2011-12, nearly doubling its open market purchases over the previous year. Since June 2008, the RBI has been a net buyer of GOI securities every year. The resultant increase in money supply in the economy has no doubt provided liquidity support in a market constrained by “crowding out” effects due to expanding government borrowing (central government public debt increased at a CAGR of 14% in the four years to June 2012). More recently, the scale of liquidity injection through open market operations have been necessitated by the need to restore liquidity in the system as a consequence of rupee liquidity absorbed out against exchange rate intervention efforts. Clearly the RBI has had to walk a tight rope between the need to stabilise the foreign exchange markets and maintaining sufficient rupee liquidity in the system. Given overall trends in the last three to four years, from a quantity theory of money perspective, it is arguable, that the desired benefits expected from monetary policy tightening (read interest rates), have been at least partially offset by persistently expanding money supply.

Valuation Gains

The second factor contributing to balance sheet expansion is on account of significant valuation gains arising out of revaluation of gold and FCA (foreign currency assets). The RBI balance sheet increased by nearly INR 2.9 trillion on account of unrealised gains due  to rise in gold prices and steep exchange rate depreciation.  As always and broadly in line with accounting practices followed by responsible central banks worldwide, the central banker very prudently carries these unrealised gains directly to its Balance Sheet under the heading Currency and Gold Revaluation Account (CGRA). Since these gains are not routed through the revenue account they are unavailable for distribution to the Government of India as a surplus for the year. In this manner, the surplus is well positioned on the RBI balance sheet and available for absorbing future valuation reversals rather than being taken to profit & loss account and its consequent diversion into immediate government spending. The need for such prudence is heightened by the fact that liberalizing economies such as India increasingly find their Central Banks more exposed to market fluctuations and need adequate cushioning through robust reserve balances from current revenue.

Gold

As a side note, the RBI is now sitting on 558 metric tonnes of total gold stock (bullion and coins). A comparison of year on year changes in gold stock indicates that the RBI did not add to its gold stock in the financial year 2011-12. A persistently high current account deficit appears to have impeded the Central Bank from augmenting its gold stock at a time when Central Banks worldwide are reported to have added nearly 450 tonnes. Clearly, gold continues to be a ‘safe haven’ asset at central banks across the globe. In the long run, it will be interesting to observe whether the RBI systematically changes its international asset composition, further, in favour of gold.

Conclusion

Persistently high headline and core inflation, consequent tight money policy, a depreciating rupee, limited fiscal headroom and the continued threat of global slowdown have meant that the RBI has had to follow a fine balancing act during the last financial year. This is clearly visible in the distinct change in composition of assets on the balance sheet and the tilt towards government securities holdings. For those interested in graduating beyond speculating on repo (interest) rate movements, future balance sheets should continue to make for interesting analysis as India navigates through the next phase of challenging economic growth.

First Published  Jan 1, 2013 on www.marketexpress.in - Financial & Business News, Analysis, Insights, Opinions & Research Portal

Auctioneer’s curse – an Indian invention

If one were to go by recorded history, auctions have been around for over 2500 years. History has it that ancient Babylon used to witness auctions for marriage of women, with eligible would-be brides themselves acting as auctioneers seeking grooms, Over time, auctions have come to be accepted as mechanisms to unlock value for objects as diverse as paintings to stamps and, at one point (unfortunately the nadir),  even the Roman Empire!

Financial markets also see their fair share of auctions every year, primarily through the sale of government securities. US treasury securities for example, are frequently sold through competitive bids limited to a certain proportion of issuance value with the balance issuance being allotted on non-competitive basis to applicants who agree to abide by the security price or yield determined through the competitive bidding route.

Most widely followed auction mechanisms have standard formats. They look to ensure that the auctioned product or right is awarded to the highest bidder – at a price which represents the ‘optimal’ valuation. However, what represents optimal value is highly situational. At best in an auction of a public good or a right, economists seem to agree that the bid price must ensure that it covers the social cost and maximises consumer welfare. Several examples abound of sound auction principles providing intended returns to the government e.g. the multi-round spectrum auction by the US FCC (Federal Communications Commission). It is the stated intent of the FCC that the objectives of spectrum auction in the US have multiple objectives, not just a focus on maximizing receipts. Those goals include “ensuring efficient use of the spectrum, promoting economic opportunity and competition, avoiding excessive concentration of licenses, preventing the unjust enrichment of any party, and fostering the rapid deployment of new services, as well as recovering for the public a portion of the value of the spectrum.” (Cited from the Center for American Progress).

In fact, empirical evidence indicates that auctioneers (sellers) end up substantially better off as compared to competing bidders in the competitive bidding process in various situations and particularly for corporate takeovers and energy exploration rights, due to the tendency to overbid and the asymmetry of information that dogs the ambitious bidder. Paul Klemperer, a renowned economist and auction theorist who assisted the UK treasury benches by designing the auction formats for the sale of 3G licensing, once famously remarked “in auction designing, the devil is in the details and there is no one size fits all.” Closer home, amidst all the muck-raising and allegation-counter-allegation drama associated with the sale of strategically important national assets, preliminary findings seem to indicate the following. At a time when the nation was poised for explosive growth and market based valuations on key public assets seemed to potentially hit the roof, an opportunity to maximise public welfare might have been missed. One argument justifying actual allotment prices is that a higher price would have meant consumers would bear the brunt and hence it is in public interest that allotment prices are kept lower! This is a tenuous argument and does not stand to reason. For there is very little that can prevent subsequent lobbying by the allottee and getting away with sale at market based pricing or second sale at windfall prices. That seems to be the case from preliminary indications.

Economists have long used the expression winner’s curse – under certain circumstances, the winner loses out by paying higher than the true valuation of the auctioned asset. What we are witnessing in India, may well be a new and antithetical phenomenon of record proportions - the “auctioneer’s curse”.

Measuring economic well-being

At a pre-conference address yesterday, August 6, Ben Bernanke addressed the importance of data measurement to economics but quickly steered his address to the basic question underlying economics.  He distinguishes the ‘what’ of economics from the ‘why’ and talks about the need and efforts currently underway to measure and report indicators of well-being. His address is available on:

http://www.federalreserve.gov/newsevents/speech/bernanke20120806a.htm

That the Fed has a stated mandate to maintain price stability and low unemployment is a given.  Ditto for most central banks around the world, indeed for all sovereign constitutions. But, does gloomy macroeconomic data always indicate persistent all-round misery? Is it possible that the reality on the ground is quite different?  Bernanke refers to research that points to a majority of people in the US and other countries reporting being happy on a daily basis in the backdrop of persistent difficulties, driven by factors beyond income and wealth. A throwback to the Easterlin Paradox, named after the pioneering economist Richard Easterlin, who found that across a cross section of countries, a rise in income beyond a certain threshold did not appear to contribute to happiness. Of course, this body of work dates back a few decades. What findings would likely emerge from the recent experiences of the 2008 financial crisis and its impact on people’s lives? One would expect a lot of this to be at the nub of current research in microeconomics. It better be.

The famous philosopher Aldous Huxley argues that human beings are by nature conservative (prone to inertia) and even desirable change should be introduced in as less a disruptive a manner to avoid violent reactions and social instability. By this yardstick, the nature of widespread adjustment imposed by the current phase of de-growth in the Western world should adversely affect cross temporal well-being for wide cross-sections of society.

It is heartening to see Bernanke highlight the need to shift the obsessive focus from macro data watching to micro behavioural analysis. A lot of what is measured and reported in economics today is a compulsive, almost self-fulfilling drive to ensure data keeps flowing to markets, so that views can be instantaneously adjusted and valuations ‘discovered’. Is the output from this process, of any utility in improving the lot of the real sector and the lives of people? These are interesting questions and need to be answered. The dismal science stands at the cross-roads but there is no better opportunity than now to focus on the ‘why’ once again.

“Actual happiness always looks pretty squalid in comparison with the overcompensations for misery. And, of course, stability isn't nearly so spectacular as instability. And being contented has none of the glamour of a good fight against misfortune, none of the picturesqueness of a struggle with temptation, or a fatal overthrow by passion or doubt. Happiness is never grand.” – Aldous Huxley, Brave New World

In America it pays to reward at school. In India, we need to start with parents.

Economists from the University of Chicago and University of Calif. San Diego recently published a research paper on how to leverage behavioural economics in education. The paper is available on NBER at http://www.nber.org/papers/w18165. The authors apply concepts from behavioural economics to the classroom across a wide spectrum of age groups and come up with interesting findings – I found three of them particularly profound. One – non financial incentives such as trophies and certificates have a significant impact on improving performance, particularly among the young. Two – incentives have greater impact when framed as losses. For e.g. providing a reward before a test with a rider to withdraw the reward if results are found unsatisfactory, resulted in superior performance. Three – delayed gratification fails to provide desired effects. On average, students perform better when they know a reward is available for superior performance immediately on completion of the test compared to a reward three months hence. The authors argue that this last finding has dramatic effects on human investment in the process of education, especially amongst urban youth.

So how relevant are these findings in countries like India, where it is conservatively estimated that one in five children do not have access to schooling and only two thirds of children who make it through primary schooling have access to higher secondary. It is estimated that over 75% of all school going children in India and nearly all school going children in rural India attend government schools. The plight of infrastructure, quality of teachers and sheer apathy towards the girl child are well documented. Drop outs are rampant due to child labour. A more appropriate study in the Indian context would probably need to focus on enhancement and retention of school attendance to start with. Which means the focus needs to be less on students and more on parents and teachers. What would incentivise parents of the average rural school going child to send their children to school and keep them in school? Since financial incentives appear to matter more as we age, would differentiated daily wages for parents of school going children, change behaviour? Would principles of loss aversion apply with greater force – so, could the threat of a loss of job for the parent of a child labourer or a school absconder, force parents to keep their children in school? Would differential direct cash transfers through India’s flagship rural employment program NREGA be one step in this direction? How would such measures be enforced and monitored in a country which has the distinction of bearing the largest number of child labourers in the world?

Brazil appears to have found a way through the problem. The Brazilian experience proves that there is no magic pill. Improving parental education, better social security, direct cash transfers, strides in education infrastructure and simpler solutions like providing piped water access at schools have all contributed their mite. An ILO / UNICEF 2011 report estimates that child labour and school attendance statistics moved in opposite directions with the former dropping over 60% between 1992 and 2008.

As always, answers to these questions hinge on governance and social will.

Sundry musings, a word of caution and speculative oil

More dope coming up on ECB monetary policy, this time from the Draghi himself – do make calendar space available on March 8:

http://www.ecb.int/press/tvservices/webcast/html/webcast_120308.en.html

In case you need background reading on monetary trends in the Euro Area ahead of the webcast, check out

http://www.ecb.int/press/pdf/md/md1201.pdf

Provides official estimates of M3 aggregate growth trends in the Euro Area and it’s counterpart on the Asset Side i.e. bank lending. Perhaps a trifle early to comment on the impact of balance sheet expansion. Observe the build up in medium term deposits on Euro Area bank balance sheets and a 50 bps uptick in annualized growth rate of M3 broad money over month ago (December 2011).  News hit the tape yesterday on record amounts deposited by Euro Area banks with the ECB linked to LTRO printing. I came across a view by Danske Bank, on why that may not necessarily indicate that the LTRO is failing to have the desired effect, when considered from the narrow objective of adequate support for sovereign bond buying across the Euro-zone: http://www.danskemarkets.com/en-gb/products-services/advisory/research/Documents/Research_ECBDeposits_040112.pdf

Interesting read, when you consider that the flow is probably:

ECB => Peripheral Commercial Banking system=> Primary and Secondary Bond market => Peripheral government / Bond seller (secondary market) bank accounts with the commercial banking system

All of the above leading to overall liquidity in peripheral bond markets, adequate deposits with the peripheral commercial banking system and the capability to expand bank lending. The key word is ‘capability’. We need to wait and watch.

Meanwhile, on the sentiment front, the impending clash of civilizations and the run up in crude does not augur well. Dr. Marc ’Doom’ Faber, talks about why he thinks gold and precious metals may well be the trade for 2012 and beyond:

http://www.cnbc.com/id/46637485

Hidden within the article is his advice on why investors would do well to stay invested in precious metals and equities……a note of optimism “most wars and most social unrest haven't destroyed corporations—they usually survive”.

Meanwhile crude price momentum continues to build up – two steps forward, one step back. And the first missiles haven’t even been fired yet! Check out some interesting graphs on build up in positions on NYMEX WTI crude futures. http://www.cftc.gov/OCE/WEB/crude_oil.htm

Since late 2011, the sharp uptrend in net (long) position build up by non-commercial traders is in contrast to the declining trend by commercial traders (those who use futures contracts for hedging). In general money managers, hedge funds and the like would fall in the non-commercial category. It appears there is considerable speculation money at the long end of oil.

The plot is getting murkier – as is often the case, the geo-political dark-horse seems to be fast emerging to the fore.