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Upholding Economic Freedom

Prohibition is conceptually against the very essence of economic freedom, apart from the various challenges in implementation. 

A hooch tragedy is on the way. It is unfortunate, but inevitable. A week after Bihar Chief Minister Nitish Kumar came to power, he announced the first implementation of his promises – prohibiting the production, storage, distribution, and sale of alcohol in his state with effect from 1st April 2016.

There’s a new wave of prohibition going around the country. Kerala declared prohibition a year ago, Bihar has just done it and Tamil Nadu might just witness it if the DMK comes to power. Interestingly enough, states in India which have had prohibition for decades are beginning to realize its folly and are lifting the ban on alcohol sales and distribution. Mizoram Finance Minister, Lalsawta, openly declared that ‘prohibition just did not work’ in his state. Manipur, which has had a prohibition for 24 years, is beginning to question its merits and might remove the ban some time soon. For a brief history of prohibition experience in various states in India, read this article in Mint.

The upcoming prohibition in Bihar is an unwise move on many grounds

The upcoming prohibition in Bihar is an unwise move on many grounds

Prohibition is objectionable on many grounds. Firstly and perhaps, most importantly, it is conceptually against the idea of economic freedom. Quite a few of us often celebrate the great strides in political freedom that this nascent democracy has made. Freedom of speech, human rights, universal suffrage, etc were achieved right at birth, notwithstanding the recent small bump on the road. However, when it comes to economic freedom, we are often shortchanged and we tend not to notice much. The idea of liberty that is enshrined in the constitution should inevitably contain within it, the idea of economic liberty. The Republic of India is not a nanny State and should not dictate our economic decisions. Yet, that is exactly the position we find ourselves in today. States impose high taxes on luxury goods and on sin products such as alcohol and tobacco, if not entirely eliminating the scope for its production, distribution and consumption. The very idea that an external entity should dictate one’s choices should be repugnant. Every citizen should have the freedom to spend her hard earned money in any way  they so please, subject to reasonable restrictions.

The second problem with prohibition is the state capacity to implement it. Every state in India that has tried to implement prohibition has failed miserably. Economics 101 tells us that supply will always creep up where there is a demand and that is exactly reflected in the ground in these states. Again, the experience of Manipur and Mizoram, states which have had prohibition for the last two decades can be telling here. Both the states have admitted that prohibition was a complete failure and that liquor has always made its way from the neighbouring states. Prohibition also leads to a law and order situation with several new ‘enterprises’ which will spring up in order to cater to this demand. Unfortunately, all these enterprises will be part of the underground economy and impossible to control and regulate.

By making it illegal, the states essentially lose control over its production and consumption. If it is legal, the states can monitor how much is consumed and can try to influence the quantity consumed through various policies. They give up this control the minute it is made illegal.

Even if the state can ensure that there is no illegal movement and trade of these commodities, it will give way to a much bigger problem. The inevitable consequence is the rise of illicitly produced liquor, which has led to far too many deaths in our country. Hooch tragedies are almost a direct result of prohibition and excessive taxation, as this article points out.

Finally, the state loses out on precious revenue streams generated by the alcohol industry. The Manipuri Chief Minister, Okram Ibobi Singh, made a case for removal of prohibition by stating that the government was unable to carry out many of its welfare schemes due to the lost revenue from taxing alcohol sales and all the benefits were being accrued by the neighbouring Assam government. The money earned through excise duty can be channeled into rehabilitation and counselling centres, as Narayan Ramachandran points out here.

It would behove the Bihar Chief Minister to heed to the lessons learnt by the experiences of other states in India, if not national governments the world over. Further, Bihar would not want to lose the growth momentum it has gained in the past decade and would want to establish itself as a modern state which respects its citizens economic freedom.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

Disclaimer: The author does not have any vested interest in arguing against prohibition.

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Primer on deficits

Today’s budgetary deficits are tomorrow’s taxes. Therefore, it is important to understand what deficit means, and how India has performed on this metric over the past few years. This post provides a primer on this topic.

Budgetary deficit occurs when the expenditures[1] are more than receipts (This is true for homes and nations).There are three types of deficits

  • Revenue Deficit
  • Fiscal Deficit
  • Primary Deficit


Revenue deficit is defined as the difference between total revenue expenditure and total revenue receipts. The revenue deficit signals how much the government is spending when compared to its earnings to perform its day-to-day activities(like paying salaries etc.)

Revenue receipts are those government receipts which neither reduce assets nor create future liabilities. These are proceeds from taxes, interest and dividend from government investment, cess, and other receipts for services rendered by the government. Revenue expenditure includes those expenditures that neither creates assets nor reduces liabilities. These are expenditures on salaries of government employees, subsidies, grants (to state government and other entities), interest payments and pensions. These expenditures are short term and recurring in nature and mostly meant to ensure the daily functioning of the government.

Given this, revenue deficit shows how much the government is borrowing to finance its daily functioning. In the past few years, eliminating the revenue deficit has been the priority for both the Union and State governments. The Fiscal Responsibility and Budget Management Act, 2003 recommended elimination of revenue deficit by 2009.

Revenue deficit = Total revenue expenditure – Total revenue receipts

Fiscal Deficit is defined as the difference between total expenditure and total receipts (excluding borrowings) ie., any loans received as money are not counted as receipts.. Therefore fiscal deficit actually represents the amount of borrowing that the government must make to meet its expenses(this is the reason why the fiscal deficit is the most discussed number and a keenly observed number during the budget and by commentators.

Fiscal Deficit = Total expenditure – Total receipts(excluding borrowings)

Primary deficit is defined as the difference between fiscal deficit and interest payments ie., if the primary deficit is zero then, the governments borrowings will be used just to meet its previous borrowings. If the primary deficit is positive and significant, it feeds back into the interest payments in the following years, as fresh debt is created, for which interest has to be paid.

Primary deficit = Fiscal deficit – interest payments


deficit gdp

[1] There are two types of expenditures: Revenue expenditure and Capital Expenditure. Revenue expenditure is a cost that is charged to expense as soon as the cost is incurred.

Varun Ramachandra and Anupam Manur are Policy Analysts at Takshashila Institution. Varun tweets at @_quale and Anupam tweets at @anupammanur

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Costly Holidays

India experiences the most disruptions to businesses due to bandhs and public holidays and there are huge economic costs attached to it.

Public holidays are usually a cause for celebration. Workers get a day off to put up their feet, relax, catch up with family and pending chores. A study revealed that India holds the distinction of being the country with the most number of public holidays in the world with 21 days off and at times more depending on the state. Mexico comes in last with 7 holidays in a calendar year.

However, not everyone equally welcomes a public holiday. In August 2015, Victorian Premier Daniel Andrews pushed a legislation to declare October 2nd 2015, the eve of the grand Australian Football League Final, as a public holiday. Many Victorian businesses and ordinary citizens protested against this. Earlier, the draft proposal was put up for comments and review by the public and an overwhelming 90 percent of the respondents were against the move. One would normally expect jubilation instead of protests for an additional holiday. The reason for the protest is purely economical. The opportunity cost of an additional public holiday is staggering $852 million worth of lost production to the state, says accounting firm PricewaterhouseCoopers. Australia has a total of 9 national public holidays.

Similarly, in the UK, many analysts subtly remarked about the economic costs of celebrating the Diamond Jubilee of Queen Elizabeth II (60th anniversary of accession). In fact, Sir Mervyn King, the then Governor of the Bank of England told the House of Lords that he expects a fall in output in that quarter due to the lost working day. A report by Centre for Economics and Business Research, suggested that each bank (public) holiday costs the UK economy about £2.3 billion and removing all ten public holidays in the UK could add up to £19 billion to the GDP.

These two countries debating the cost of additional public holidays have lesser number of public holidays than the global average and far lesser than India. In India, checking the documents by Ministry of Personnel, Public Grievances, and Pensions, there are about 15 compulsory national (gazetted) holidays, 3 additional holidays from a list of 12 and about 34 restricted (optional) holidays. In addition to this, there are numerous nationwide bandhs called by trade unions, youth organisations, political parties and any other organisation that seeks to disrupt daily life in order to achieve their objectives. Then, there are state-specific bandhs, which seek to register a protest against a regional problem. Karnataka has seen many such bandhs in the previous few years over the Kaveri issue.

What is the cost of these holidays and bandhs on the Indian economy? The CII, FICCI and Assocham have at various points come out with estimates of cost to the economy and the number ranges from Rs.10,000 crore to Rs.26,000 crores[i]. The cost of public holidays will be much lesser, as there is no complete cessation of economic activity, as it does in a bandh. The method of estimation might not be entirely correct and the actual number might be much lesser. Even if we assume a number that is a tenth of the estimated, it is deeply significant, considering the sections of society that are most affected by such disruptions.

Many businesses get adversely affected by public holidays and bandhs.

Many businesses get adversely affected by public holidays and bandhs.

A more pertinent question is: who is affected the most by these holidays and bandhs? The salaried employees of either private or public companies do not lose their wage for the day and would thus welcome a holiday. However, it is the small businesses and the poor who get most affected by these disruptions. The average daily wage earner has quite a lot to lose by ceasing his/her normal activities and losing a day’s wage.  The small canteen which relies on daily trade by the big office next door cannot make up that trade on another day. Contracted or casual factory workers often cannot afford to lose a day’s pay. Public holidays can also be severely damaging to business continuity and momentum.

Resolving the situation requires two acts:

First, implement Supreme Court’s judgement on bandhs, which held those who called the strike liable for the disruption or damage, and observed that organisations calling the strike will have to compensate for the loss. This should be expanded to include the opportunity cost as well and not just tangible damage to property. It should also be firmly established that bandhs are unconstitutional and should be banned from public life.

Second, reduce the number of public holidays and simultaneously increase freedom to choose holidays. The G20 average for number of public holidays stands at 12. That could be adopted here. However, except three national holidays (Independence Day, Republic Day and Gandhi Jayanti), the rest of the seven days should be a choosing of each individual, based on their preferences. Mandatory religious holidays do not make sense in a secular democracy.

Reducing the loss of business days can add significantly to the GDP, provide a stable environment for business and most importantly, can help the poor earn that extra day’s income.

Anupam Manur is a Policy Analyst at Takshashila Institution and tweets @anupammanur

[i] For a brilliant exposition of the calculations behind estimating the cost of a bandh, read this brilliant piece by Prof. Bibek Debroy

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Outrageous Outages

The economic cost of power cuts to India is as high as 1% of GDP. It is time to reclaim that through proper pricing, privatisation and better management of supply.

Karnataka is experiencing dark days. Many parts of Karnataka are experiencing disruptions in power supply, or outages, for 8 to 10 hours in a day. Bangalore, the capital of Karnataka and IT capital ofIndia, has been experiencing three hours of scheduled power cuts and a few more hours of bonus unscheduled ones. Starting from today, Bangalore Electricity Supply Company (BESCOM) officially extended the scheduled power cuts from three hours to four.

Night time satellite image  of power cuts in Karnataka

A slightly modified night time satellite image showing Karnataka in darkness due to the power cuts.

Power cuts of this nature in a major metropolitan area are nearly unheard of and Bangalore’s aspiration to become a global hub for business and innovation is under serious threat. Power disruptions are exactly that – they disrupt the everyday lives of citizens and businesses. There are plenty of news reports and stories of ordinary lives getting disrupted due to the power cuts. Inconvenience to citizens aside, power cuts have huge economic costs to businesses.

A study by Federation of Indian Chambers of Commerce conducted a survey on the cost of power cuts to businesses in India and the numbers are staggering. The study revealed that Indian companies are losing up to 40,000 rupees ($733) a day each because of power shortages, which are taking a toll on production. The survey, which covers 650 industries of various sizes across India, said that as many as 61% of the companies surveyed suffered more than 10% loss in production due to power cuts.

This 2009 report in India Today surveys the extent of economic costs to Indian companies. It quotes a study by Manufacturers’ Association for Information Technology (MAIT) and Emerson Network Power estimates that the cost of power disruptions to India Inc is to the tune of Rs. 43,205 crores (nearly 1% of GDP) per year. Manufacturing is, quite understandably, the worst hit sector, followed by financial services, Telecom, real estate and infrastructure. The estimate loss for firms in these sectors is a whopping Rs 54,434 per hour, as the report states.

Where is the light at the end of the Tunnel?

Every summer and sometimes during the post-monsoon period, the government has a pre prepared statement for the reasons for power cuts: shortage of rainfall, technical glitches in the power plants, thermal plants being shut for maintenance, etc.  However, the real reason for the constant power problems is the mispricing of electricity.

Comparison of average national cost of electricity. Source: http://www.theenergycollective.com/lindsay-wilson/279126/average-electricity-prices-around-world-kwh

Comparison of average national cost of electricity. Source: http://www.theenergycollective.com/lindsay-wilson/279126/average-electricity-prices-around-world-kwh

Electricity is cheap in India. A bit too cheap. The recently revised tariff for domestic consumers in urban areas in Karnataka will be Rs 2.70 per unit for 30 units, Rs 4 per unit for consumption between 31 and 100 units, Rs 5.25 per unit for consumption between 101 and 200 units and Rs 6.25 per unit beyond 200 units per month.

Further, there are two types of price discrimination that takes place in India. One is based on the type of consumers. Higher rates for industries and low rates/free electricity for farmers, etc. The second discrimination is based on the quantity consumed – per unit cost increases with higher number of units consumed.

The first type of price discrimination is done in order to enforce cross-subsidization of electricity. It ensures that industries pay for the farmer’s electricity. This has got to be stopped, just as diesel and cooking gas subsidies are being dismantled. All ESCOMs (Electricity Supply Companies) in India are under severe losses, which reduces their ability to ensure continuous supply of electricity by maintaining the plants, having a regulatory and enforcing structure to reduce theft of electricity and finally to reduce leakages in the distribution channels.

Price discrimination based on quantity consumed will ensure proper pricing of electricity. The higher number of units consumed, the more one pays. Big industries will naturally pay more than common households, but not as much as the present system. Small to medium enterprises may also end up paying more, but it would be significantly lesser than the opportunity cost of losing business due to power cuts plus the cost to arrange alternate modes of electricity production (diesel generators, etc).

Privatisation: It is time that the government realizes that more than half of India’s future power generation and supply should and will be done by the private sector. Incentivize the private sector to invest in power generation capacity.

Scientific management of power supply: ESCOMs in India should operate the way a private firm does: project production quantities, possibilities for production disruption, alternatives for mitigating the disruptions, predicting hike in demand, etc. It is surprising that the State Electricity Companies quote hike in demand as the reason for power shortages every summer. The meteorological department had announced well in advance that the monsoon this year will be below average and yet, it managed to catch the Power ministry and BESCOM by surprise.

Predicting increased demand and forecasting supply shortages will help the companies to prepare alternatives in advance. BESCOM can introduce special seasonal tariffs for summer or prepare for a weak monsoon by making arrangements to buy power in advance.

Reforms in the power sector have been in the public sphere for far too long without any concrete action. Smart cities, Make in India and any such ambitious projects will remain a dream until continuous supply of electricity is sorted out. It is time to reclaim the lost 1% of GDP due to power cuts.

Anupam Manur is a Policy Analyst at Takshashila Institution and tweets @anupammanur

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Good Intentions, Bad Implementation

While the intention of providing ISBNs for free can be lauded, the inefficiency in the system, the time delays and the complex procedures hampers the larger intention of encouraging publications of more books.

Recently, the Takshashila Institution published its first book “A Visible Hand” by Narayan Ramachandran. Narayan has written scores of articles/essays on various topics and the book is a collection of his finest writings – essays on the intersection of politics, economics and society. The next step after publishing the book is to make it market ready. To commercially sell this book, one requires an International Standard Book Number (ISBN), such that it can enter the catalogues of the sellers and makes the transaction of buying and selling the book easier. The ISBN is a 13 digit unique commercial numeric identifier that is assigned to each publication, which is then updated to the database.

Though it is an international standard number, each country has a different agency that assigns the ISBNs and thus, each country has different procedures to acquire it. Many countries have outsources this job to the private companies, like R.R Bowker in the US, Nielsen Holdings in the UK, etc. Many other countries have a governmental agency that deals with issuing ISBNs, such as the Library and Archives Canada, the National Library of South Africa, etc. Irrespective of whether it is a government or a private agency, the process is a fairly simple one that can be done online and the response time should be fairly short. The Bowker’s website, for example, provides ISBN numbers and a barcode immediately after the payment of a fee.  Though the process is easy, acquiring an ISBN in the US or UK is quite an expensive affair – it costs $125 for an ISBN in the US and £120 in the UK.

The 13 digit International Standard Book Number

The 13 digit International Standard Book Number

In India, with the noble intention of encouraging more people to write and publish books, the Ministry of Culture issues the ISBNs free of cost for publishers, authors and educational institutions. It has set up the Raja Rammohun Roy Library Foundation as the agency responsible for issuing ISBNs in India. While the intention of providing ISBNs for free is good, the inefficiency in the system, the time delays and the complex procedures hampers the larger intention of encouraging publications of more books.

Specific problems with getting an ISBN:

Time: Getting an ISBN in India takes, on average, more than a period of two months. There are instances where people have waited more than six months in acquiring the ISBN and this can be hugely frustrating for either publishers or individual authors who have invested significant effort, time and money in publishing a book.

Procedure: Only one ISBN is awarded per application for individual authors. Publishers however, get a block of 10 ISBN numbers that they can use for their future publications.

The application form is fairly simple, though there is one question that almost no one knows how to answer. The question is “Category in which applied (5/4/3/2/1)  ___”. Even after an extensive search on the internet, it is still not clear as to what categories they are alluding to. Many aspiring authors have asked for help on the same question in different user forums and have not received any answer. The agency has not yet responded to either mail or telephone calls.

Further, the application form has to be sent by snail mail to Delhi, which further increases the time, effort and uncertainty in obtaining the ISBN.

Another remarkable feature is that educational and research institutions cannot get an ISBN for books they might publish. They can get one only for seminar/conference proceedings. It is rather strange that the agency does not envisage educational and especially research institutions to publish books.

Experience: Many users have reported through their experience that the only way to obtain an ISBN is by personally visiting the office in Delhi and submitting the form. Anecdotal evidence suggests that the applications sent by mail are not processed quickly nor is an acknowledgement receipt sent.

Time-Cost Tradeoff

Thus, it essentially boils down to a time-cost trade-off. Does the free ISBN warrant the laborious procedure and the uncertainty? Publishers might not mind paying a bit to get the ISBN quickly and easily, such that they can sell the product in the market and profit.

The Ministry of Culture has a large dataset to look into the most efficient systems in the world, since each country has an agency to issue the ISBN. It can look into the various options to make the process smoother. It can outsource it to a private company and either let them charge their own fee or subsidize it. If it wants to run the agency itself, it can consider charging a nominal fee and use it to move the entire system online and quicken the procedure.

Ultimately, it should not be forgotten that providing a free service (ISBNs) was a means towards a greater end of getting more published books. Any solution should answer the bigger objective.

Anupam Manur is a Policy Analyst at Takshashila Institution and tweets @anupammanur

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Random Observations from the BBMP elections

Urban local elections in India have historically witnessed a low voter turnout and the BBMP elections may not be an exception. Despite the ease of obtaining voting information from the internet, many people still prefer to wait for a long time to get it manually. 

A Takshashila Thinktanki votes in the BBMP elections.

A Takshashila Thinktanki votes in the BBMP elections.

Low Voter Turnout

On the day of the BBMP elections (22nd August 2015), the Shantiniketan School ground, BTM Layout, at 10:30 in the morning was surprisingly empty. Potential voters could walk right into their polling booths and cast their vote without waiting in a long queue as would normally be the case in the state or general elections. There was no queue outside any of the polling booths. Other voters shared similar experiences from different wards in Bangalore.

It would be interesting to note the voter turnout percentage this time. Despite various campaigns by the government, various political parties and many businesses, voting turn out is set to be low. Media reports that voter turnout was about 10% until noon – 7.3 lakh persons voted out of 7.38 lakh registered voters. It would not be very surprising if it were significantly less than 50 percent by the end of the day, going by the past trends. In 2010, BBMP elections witnessed less than 45 percent turnout. Within Bangalore, the affluent areas have traditionally witnessed much lower turnout. In 2010, many affluent areas saw voting turnout percentages between 25 and 30.

It is a similar story in all the big cities – voter turnout has been dismal for the elections that has the most direct influence on a citizen’s life. Mumbai corporation elections witnessed 46% turnout, the same numbers for Hyderabad GHMC elections, Chennai – 48%, Delhi – less than 40%, Ahmedabad – 44%. [Link].

Language Problem and Importance of Symbols – Whitefield, the contentious part of Bangalore, saw many people complaining that the EVMs contained the candidates names only in Kannada and that they were unable to read the list of candidates. Thus, many supposedly walked out of the polling booth without registering a vote. [Source] While symbols help in recognition of candidates from the main parties, independents tend to get short changed.

Voter’s Slip

It is quite common to see that there are numerous benches and desks occupied by different party workers outside the polling stations. These are usually mobbed by the potential voters to get their Ward no, serial number, polling booth, room number and their EPIC (Electors Photo Identity Card) number. One can go to these temporary stations with their name and a photo identity and the party workers will sift through many pages containing the entire ward’s electorate information and give the appropriate details. This is quite a labourious process and can potentially rob one’s enthusiasm to vote. The 2014 general elections for example in the same ward saw a waiting time of more than 20 minutes just to get this information and then wait in a separate queue to vote.

It is quite surprising that many people who have easy access to the internet still prefer to do this instead of going to the website and finding out the same details easily. The Election Commission has made this process extremely easy. Go to the relevant website ( for the BBMP elections), key in name, father’s/husband’s name and the area name that you live in and all the details will be available.

Manifestos and Promises

Finally, it was slightly disturbing to read the manifestos and the general pitch of the candidates in my ward during this election. Many of the candidates do door to door campaigning and also leave behind a small booklet or a pamphlet. I have kept aside the manifestos of all the five candidates for BTM Layout and none of them really inspired me to cast my vote for them (most of them had grievous spelling and grammatical mistakes).

Some of the manifestos were too vague and general regarding their plans for the coming term – “I will work for the development of our ward”. Others centered around extremely specific work they have done and hope to do – “I have distributed x. number of sewing machines to the needy”. One candidate mentioned that he had solved many personal problems when I asked him about his achievements.

Unfortunately, the perceived purpose of the manifesto is not to inform the voter of any achievements or their grand vision and plans for the ward, but is meant to serve as a reminder of their photo and the election symbol.

Anupam Manur is a Policy Analyst at Takshashila Institution and tweets @anupammanur

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The Need for Clarity in the Revised IFC

Six new financial agencies with no clear mandates – the draft Indian Financial Code has to be redrafted to reduce the number of conflicting agencies and give clearer mandates to any new agency it will create.

The draft Indian Financial Code has been in the limelight since the time the Finance Ministry put it online and welcomed comments. The main criticism against the code is that it substantially weakens the Reserve Bank of India, by taking away many of its existing powers. More specifically, the substantial part of the criticism is directed against the Monetary Policy Committee (MPC), the composition of its members and what it would imply for the conducting of monetary policy in India. The MPC, according to the draft IFC, will contain seven members, of which four will be selected by the Central Government and three from the RBI. This obviously fosters fear of transferring monetary policy powers from the RBI to the government, because of the majority in MPC held by the latter.

While the brouhaha over the MPC is justified, it is preventing adequate attention to be given to other aspects of the draft IFC that deserves it. One of the principal, yet flawed recommendations of the IFC is the creation of a seven-agency structure for the financial sector — the Reserve Bank of India (RBI), Unified Financial Agency (UFA), Financial Sector Appellate Tribunal (FSAT), Resolution Corporation (RC), Financial Redressal Agency (FRA), Financial Stability and Development Council (FSDC) and Public Debt Management Agency (PDMA).

The RBI currently manages the functions that are designated to these agencies, namely monetary policy, financial stability, banking regulation, regulation of non-banking financial institutions, forex management, deposit insurance and credit guarantee and payment and settlement systems. However, after the creation of the six other agencies, the RBI will be partially in charge of monetary policy (via the MPC), banking regulation and only systematically important payment and settlement systems.

The creation of the Redressal and Resolution agencies, which are independent, have some merit, as their mandate is to protect consumers. However, other agencies and their functions are contentious as there is very little clarity over their exact mandates.

The six new financial agencies and the RBI with conflicting mandates will be fighting for control over the steering wheel. Illustration by C.R Sasikumar. Source: http://indianexpress.com/article/opinion/columns/a-code-too-soon/

The six new financial agencies and the RBI with conflicting mandates will be fighting for control over the steering wheel.

Banking regulation has been, fortunately, left with the RBI. However, the Unified Financial Agency has been given the regulatory power over all non-banking financial institutions (NBFCs) and payment systems. This could include segments of the markets such as securities, commodities, NBFCs, Micro Finance Institutions, insurance, etc. Separating banking regulation (with RBI) from that of other, non-bank credit institutions (with UFA) will create many possibilities of regulatory arbitrage, and could lead to financial instability.

Looking at the Public Debt Management Agency (PDMA), the mandate is to make the market for government securities liquid and to keep the costs of borrowing down. It is clear then that the PDMA will strive to keep the rates down through participation in the G-Sec markets. This will severely hamper RBI’s operations in the secondary markets through its Open Market Operations (OMO). The PDMA will have seven members, of which four will be chosen by an expert selection committee (who chooses these members?), and one each from the RBI, central government and the state governments in turn.  Envisage a situation where the government has accumulated large amounts of public debt, which has increased the cost of borrowing and the rate of inflation. The two main instruments of the RBI to fight this scenario are through control over the policy rate and through open market operations. However, in the new system, the MPC may not allow an increase in the policy rate and any RBI OMO operations will be dominated by actions of the PDMA.

The Financial Stability and Development Council has the mandate to evaluate and manage the systemic risks in the financial system. This functioning is closely linked and inalienable to the function of regulation of the banking system, which lies with the RBI. How does the IFC imagine the FSDC to manage and mitigate systemic risks without having the power to regulate the banking sector?

Each of these agencies will have different mandates and views, which might conflict with the other agencies. Further, each agency will have members belonging to the government, RBI, or independent experts, who will try to pursue their own agenda. It should also be remembered that there already exists a host of other regulatory bodies in the financial space: SEBI, FMC, IRDA, PFRDA, NABARD, etc. How will the actions of all of these financial agencies be coordinated to pursue a higher agenda of financial stability, price stability and long term sustainable growth?

Finally, a surprising omission from the draft IFC is the control over exchange rates. As it is well known, the exchange rate of the Indian rupee is not entirely determined by the market forces. The RBI intervenes from time to time to either reduce volatility (stated mandate) or to maintain the exchange rate at ‘comfortable levels’ (unstated). An exchange rate policy cannot be independent of monetary policy and forex management. Then, will the MPC be in charge of exchange rate management as well? If so, it can create all sorts of distortions in the economy. The government may try to have a ‘strong’ currency out of a misplaced sense of pride.

The Financial code will have to be redrafted to reduce the number of conflicting agencies and give clearer mandates to any new agency it will create. Finally, it will need to look at the justification behind its attempt to fix a system that is not broken and not tinker with the well functioning aspects of the financial system.

Image Source: http://indianexpress.com/article/opinion/columns/a-code-too-soon/       Illustration by C.R Sasikumar.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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A Fiscal Lesson for Monetary Policy

Is it wise to entrust monetary policy to the central government, when it has consistently failed to achieve its fiscal and revenue deficit targets?

The Finance Ministry has put up the revised draft of the Indian Financial Code (IFC) on its website and has invited comments from the general public. Its many drastic proposals have invited much outrage from economists with the main target being the structure of the monetary policy committee. Earlier this year, the Reserve Bank of India and the Finance Mininistry came to an agreement to form a monetary policy committee (MPC) and also agreed on adopting inflation targeting. The draft IFC goes on to expound the structure and functions of the MPC:

Part XI “Reserve Bank”, Chapter 64 – Objectives and Functions of the Reserve Bank; Clause 256:

  1. The Reserve Bank must constitute a Monetary Policy Committee to determine by majority vote the Policy Rate required to achieve the inflation target.
  2. The Monetary Policy Committee will comprise –
    • (a) the Reserve Bank Chairperson as its chairperson;
    • (b) one executive member of the Reserve Bank Board nominated by the Reserve Bank Board;
    • (c) one employee of the Reserve Bank nominated by the Reserve Bank Chairperson; and
    • (d) four persons appointed by the Central Government.

Thus, the MPC will consist of seven people, the majority of which (four) will be from the central government. Since it is stipulated that the interest rate will be set by the MPC on the basis of a majority vote, the government will get a greater say in the determining of monetary policy than the RBI. Further, the chairperson of the MPC (the RBI chairperson) does not get a veto vote. This is essentially the heart of the heated debate on the transfer of control of monetary policy from the RBI to the central government.

Why is this a bad thing?   

The issue boils down to whether the government can be trusted to keep the long term interests of the economy in mind while making monetary policy decisions. The trends in fiscal policy can point towards the answer. As Anantha Nageshwaran points out, “the Indian economy is inflation prone and fiscal populism, is its biggest contributor. From loan waivers to corporate give-aways, fiscal policy primes the pump needlessly on many occasions for non-economic considerations.”

It is difficult to trust a central government (irrespective of which party in power) which has failed to adhere to its own rules regarding fiscal policy. The government passed the Fiscal Responsibility and Budget Management Act (FRBMA) in 2003 with the intention of reining in the ballooning fiscal and revenue deficits. It planned to reduce fiscal deficit to 3% of GDP and eliminate revenue deficits by 2008, though this deadline was later extended to 2009 without any opposition. However, by 2009 the revenue and fiscal deficits were as high as 4.7 and 6.2 per cent of GDP respectively.  From 2009 to 2012, the FRBMA targets were never met as can be seen in Figure 1.

The events after 2012 are even more disturbing. The budget speech of 2012-13 contained amendments to the FRBMA which diluted targets and extended deadlines. The amendments extended the deadline to reduce the fiscal deficit to 3% to 2017 and increased the targeted revenue deficit to 2% instead of 0% (to be achieved by 2015). May, 2013 witnessed further dilutions and extensions of the targets.

Figure 1: The central government has consistently failed to meet its targets for containing fiscal and revenue deficits.

Figure 1: The central government has consistently failed to meet its targets for containing fiscal and revenue deficits.

There are multiple reasons for the central government’s failure to adhere to its own targets. However, the essential problem lies with the inherent short term growth bias of the central government as these posts have elaborated. Political considerations like re-election make the central government more than willing to consistently spend more than it earns despite the risks of higher future inflation and increased interest rates.

This begs the question as to how the central government can be entrusted with conducting monetary policy when such a task requires a long term perspective. “There is thus plenty of reason in the Indian context for the central bank to remain in a perpetual vigilant and adversarial mode. It provides the vital check and balance”, as Anantha Nageswaran elaborates. Thus, if the IFC is insistent on setting up an MPC, it should revisit the composition of members and should tilt the balance away from the political central government and towards the RBI.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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The Macroeconomic Case for Central Bank Independence – II

Independence of the Central Bank results in low average inflation rates with minimal variance, which provides a conducive environment for high and sustainable growth.

Part I explored the inherent growth bias in an elected government and the reason why the government would be willing to tradeoff higher growth rates for a slightly increased inflation rate. The short run Phillips curve explains this phenomenon, while the Long Run Phillips Curve or the Expectations Augmented Phillips Curve shows that there is no long run tradeoff between the two variables in the long run and further, that any policy that tries to take advantage of the short run Phillips curve will end up with lower growth rate and a higher inflation rate. While fiscal policy still falls trap to the short run Phillips curve in many countries today, subjecting monetary policy to this line of thought will result in a stagnated economy with high inflation, which has very real economic costs to the population.

Milton Friedman, in all his wisdom, demonstrates the effects of monetary policy conducted with short term visions:

When the alcoholic starts drinking, the good effects come first; the bad effects come only the next morning, when he wakes up with a bad hangover – and often cannot resist easing the hangover by taking the ‘hair of the dog that bit him’.

The parallel with inflation is exact. When a country starts on an inflationary episode, the initial effects seem good. The increased quantity of money enables whoever has access to it – nowadays, primarily government – to spend more without anybody having to spend less. Jobs become more plentiful; business is brisk, almost everybody is happy at first. Those are the good effects.

But then the increased spending starts to raise prices. Workers find that their wages, even if higher in dollars, will buy less; businessmen find that their costs have risen, so that the higher sales are not as profitable as had been anticipated unless prices can be raised even faster. The bad effects are emerging: higher prices, less buoyant demand, inflation combined with stagnation.

As with the alcoholic, the temptation is to increase quantity of money still faster.. In both cases, it takes a larger and larger amount of alcohol or money, to give the alcoholic or the economy, the same ‘kick’.

— Milton Friedman in Money and Mischief: The Cause and Cure of Inflation.

This is the theoretical case for Central Bank independence which has a long term vision.

Empirically, economic literature on this subject is not definitely in favour of central bank independence, though the dominant thinking is for independence. Grilli, Masciandaro, and Tabellini in 1991 developed an index for measuring central bank independence. The index mainly tried to measure two factors: political independence and economic independence. These factors comprise the following sub-factors:

Figure 1: Showing the various factors that comprise political and economic independence of Central Banks.

Figure 1: Showing the various factors that comprise political and economic independence of Central Banks.

Mainly, central bank independence has to be thought of in two main areas. Firstly, does the central bank have goal independence? Many central banks are given the mandate of price stability or the dual mandate of growth and price stability by the government. Secondly, does the central bank have operational/instrumental independence? In this kind of independence, the central bank can choose its instruments for achieving its policy goals and the timing of its use.

The strongest evidence for central bank independence is given by a simple regression plotting level of inflation and measures of central bank independence. The figure below shows inflation and central bank independence for industrialized economies using data from 1955 to 1988.

Figure 2: Showing the relationship between inflation rates and central bank independence for the period 1955-1988. Source: Alesina and Summers (1993)

Figure 2: Showing the relationship between inflation rates and central bank independence for the period 1955-1988. Source: Alesina and Summers (1993)

More modern studies have also been able to replicate this particular relationship.

Figure 3: Showing the relationship between inflation and central bank independence for 1995-2005.

Figure 3: Showing the relationship between inflation and central bank independence for 1995-2005.

Finally, studies have also shown that central bank independence is strongly correlated with lower variance in inflation. The Alesina and Summers paper show this graphically for the same period.

Figure 4: Showing the relationship between Central Bank independence and variance in inflation.

Figure 4: Showing the relationship between Central Bank independence and variance in inflation.

Thus, central bank independence results, more often than not, in low and stable inflation rates. Low and stable inflation rates, as economic theory has repeatedly proved, provides a conducive environment for GDP growth.

Thus, to achieve high growth rates, the central bank must be independent and must strive to achieve low and stable inflation.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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