PM Modi, Nehruvian Economic Policies Aren’t Going to Get Us Anywhere

narendra_modi
This is something that we should have written on a while back, but as they say it is better late than never.

In the annual budget of the government of India, presented earlier this month, the finance minister Arun Jaitley raised custom duties on a whole host of products. In his speech, Jaitley made it clear that this wasn’t a one-off thing, but a change in policy direction.

As he said: “In this budget, I am making a calibrated departure from the underlying policy in the last two decades, wherein the trend largely was to reduce the customs duty. There is substantial potential for domestic value addition in certain sectors, like food processing, electronics, auto components, footwear and furniture. To further incentivise the domestic value addition and Make in India in some such sectors, I propose to increase customs duty on certain items. I propose to increase customs duty on mobile phones from 15% to 20%, on some of their parts and accessories to 15% and on certain parts of TVs to 15%. This measure will promote creation of more jobs in the country.”

The customs duty has been raised on around 45 products. The maximum increase was in case of cranberry juice from 10% to 50%. (All you cranberry juice drinkers out there, maybe it is time to start appreciating the taste of chilled filtered water with a dash of lemon in it).

The idea as Jaitley explained is to create jobs within the country. With increased custom duties, imported goods will become expensive. This will make domestic goods competitive. As people buy more and more of domestic goods, the companies producing goods in India will do well. Once they do well, they will expand and create jobs in the process. Alternatively, because imports will become uncompetitive, the domestic companies can continue operating, and jobs can thus be saved. QED.

The problem with this argument is that it stinks of Nehruvian era economic policies, in particular import substitution, which was the norm in independent India, up until the economic reforms of 1991. Import substitution as a policy was introduced by Jawahar Lal Nehru and carried forward by Indira Gandhi, two individuals, the Bhartiya Janata Party keeps blaming for everything that is wrong in this country (even though we are four years into the term). At its simplest level, import substitution is basically an economic policy which promotes domestic production at the cost of imports. And it is an economic policy, which doesn’t work.

As the French economist Jean Tirole writes in Economics for the Common Good: “In economic matters too, first impressions can mislead us. We look at the direct effect of an economic policy, which is easy to understand, and we stop there. Most of the time we are not aware of the indirect effects. We do not understand the problem in its entirety. Yet secondary or indirect effects can easily make a well-intentioned policy toxic.”

What does Tirole mean here? Another French economist Frédéric Bastiat explains what secondary or indirect effects are, through the broken window fallacy.

Bastiat basically talks about a shopkeeper’s careless son breaking a pane of a glass window. He then goes on to say that those present would say: “It is an ill wind that blows nobody good. Everybody must live, and what would become of glaziers if panes of glass were never broken.

The point being that if windows weren’t broken, how would those repairing windows, the glaziers that is, ever make a living. This seems like a fair question to ask, but things aren’t as simple as that.

As Bastiat writes in Essays on Political Economy: “This form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.”

Bastiat then goes on to explain what exactly he means by this. Let’s say replacing the pane of the broken window costs 6 francs. This is the amount that the shopkeeper pays the glazier. If the shopkeeper’s son would not have broken the window there was no way that the glazier could have earned these six francs.

As Bastiat puts it: “The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.” This leads us to conclude that breaking windows is a good thing because it leads to money circulating and those who repair broken windows doing well in the process.

Nevertheless, this is just one side of the argument. As Bastiat writes: “It is not seen that our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps have replaced his old shoes, or added a book to his library. In short, he would have employed his six francs in some way which this accident prevented.”

How does this apply in the case of the Narendra Modi government increasing custom duties on a whole host of products? The seen effect of this, as already explained above, is that domestic Indian companies can compete with cheaper imports because of the custom duties being increased. This is likely to create jobs and if not, it is at least likely to save jobs. This is the first order effect or the seen effect.

What is the second order effect or the unseen effect? It is well worth remembering here that consumers only have so much money to spend. If cheaper imports no longer remain cheaper because of an increase in custom duties, the consumers have to pay a higher price for the goods made by domestic companies. Once this happens, they are likely to cut their spending on some other front.

The trouble is that this some other front on which consumers cut their spending, is not easily identifiable. Once consumers cut their spending on other fronts, some domestic businesses are not going to do well, and jobs will be lost there. The trouble is this is not something which is very obvious. It is an unseen effect.

If the consumers keep spending the same amount of money as before, they will end up cutting down on their savings, which isn’t necessarily a good thing. As Henry Hazlitt writes in Economics in One Lesson: “The fallacy… comes from noticing only the results that are immediately seen, and neglecting the results that are not seen.”

Another point that needs to be made here is that the domestic companies are organised well enough to lobby with the government. The end consumer never is.

Increasing customs duties is not a solution to creating jobs. For jobs to be created Indian firms need to be globally competitive. When companies produce for the global market, they need to compete with the best in the world. This automatically leads to a situation wherein the products which a company produces need to be globally competitive. On the other hand, when import substitution is the norm and companies need to produce just for the internal market, almost anything goes. This explains why the Indian corporate sector on the whole, has not been able to be competitive on the global front. It has still not been able to come out of the import substitution era. (We hope people do remember the Ambassador Car which had the same engine between 1944 and 1982.)

In order to be globally competitive, India needs to introduce a whole host of reforms, from labour law reforms to land reforms. It needs to start pricing electricity correctly. The governments need to control their fiscal deficits to ensure that they don’t push up interest rates in the long-term. Our education system needs a paradigm shift (We find this phrase absolutely cringeworthy, but nothing explains the situation better). The corporate bond market needs to function much better than it currently is. The number of inspectors that an average business needs to deal with has to come down. The paper work needs to be simplified. All these distortions in the system need to go.

Long story short—going back to Nehruvian economics is not going to do any good to the country. The sooner Narendra Modi understands this, the better it will be for India. India has suffered enough because of the mess initiated by the economic policies of Nehru and Indira Gandhi. And there is no point, going back to it.

The column originally appeared in Equitymaster on February 19, 2018.

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India’s Rs 1,66,276 Crore Problem

rupee
One of the major points that we talk about in India’s Big Government is the fact that the Indian state is overambitious. The government wants to do too many things at the same time, and ends up making a mishmash of everything.

One of the areas where the governments (both central as well as state governments) devote a lot of their time and attention are public sector enterprises. In the past columns, we have discussed many cases of central public-sector enterprises continuing to bleed and the government continuing to bail them out, year on year. This includes loss makers like Air India and Hindustan Photo Films Manufacturing Corporation, which have been losing money for many years.

In fact, very recently, the government revealed the losses of the perennially loss-making Air India, in the Lok Sabha. For 2016-2017, the government owned airline made losses of Rs 5,765 crore. Despite all the government spin around the airline working in a much better way, than it was in the past, the losses increased by 50%. In 2015-2016, the losses of the airline were at Rs 3,837 crore. With these numbers, it is surprising that a few media houses chose to report the fact that the operating profit of Air India, had improved year on year. But how does that matter, when the losses have gone up by 50%?

The airline has lost a total of Rs 41,657 crore, between 2010-2011 and 2016-2017. It continues to function on back of the government investing money in it, every year. Between 2011-2012 and 2017-2018, the government has invested a total of Rs 26,545 crore, into the airline. Of course, as we keep saying, every extra rupee invested in this airline, is a rupee taken away from more important areas like defence, education, health, agriculture etc.

Over and above this, the banks give the airline working capital loans. These loans as of March 31, 2017, amounted to Rs 31,088 crore. The question is why do banks give an airline which has accumulated losses of greater than Rs 41,000 crore, more loans? The answer lies in the fact that Air India is ultimately owned by the Indian government. No private sector airline in a similar situation, will get bank loans.

And lending to Air India is essentially lending to the government. Any default on loan repayment by Air India will be seen as a default by the Indian government. Hence, the assumption is that such a default is never going to happen. Given this, banks are happy to keep giving loans.

The point in throwing all these numbers at you, dear reader, is to show you, that it takes a lot of money to keep a “dead elephant” like Air India, alive. It is beyond the government babus who run this airline, to breathe life into it. With every new appointment at the top, we are told this gentleman will now revive the airline. But that hasn’t happened in years.

Meanwhile, the government continues to invest money in the airline. At the same time, the accumulated debt of the airline stands at Rs 48,447 crore (this includes aircraft loans over and above, the working capital loans). The good part is that the total debt is down from Rs 52,817 crore as of March 31, 2016. This is ultimately, the liability of the government of India, which actually does not show on its books.

In the recent past, there has been some talk about selling the airline, lock, stock and barrel. But then, until things really happen, talk is just talk. In fact, the government has been talking about selling the airline since June 2017. The proof of the pudding, as they say, is in the eating.

Air India, over the years, has become a poster boy of the government owning and continuing to run, loss making enterprises. This problem is well known at the central level. In 2015-2016 (the latest set of agglomerated numbers which are currently available) 78 out of the 244 central public sector enterprises, were loss making. Of these nearly half of the companies had made losses three years in a row. Further, between 2006-2007 and 2015-2016, a period of a decade, the net profit to capital employed ratio, of the central public sector enterprises has fallen from 12.27% to 5.97%. This tells us how well the government’s capital (or in other words the taxpayer’s capital) is being put to use.

The story of central public sector enterprises not doing well has been well highlighted over the years. But the same cannot be said for public sector enterprises owned by the state governments. Economist Vijay Joshi in a recent lecture pointed out: “In addition to Central PSEs, there are around 1000-odd State PSEs, of which two-thirds make losses, including notably the zombie electricity distribution companies. The aggregate losses of all PSEs, central and state, amount to about one per cent of GDP annually.”

One percent of  the GDP is not a small amount. The GDP (gross domestic product) at current prices for 2017-2018 is projected to be at Rs 16,627,585 crore. One percent of this works out to around Rs 1,66,276 crore. This is a large amount of money.

Of course, a lot of this amount, the government is not currently paying for directly. Many public sector enterprises borrow from banks, in order to make up for their losses. The banks lend them money simply because these companies are ultimately owned by the central and the state governments.

Hence, the total liabilities of the government keep increasing day by day and will have to be paid for one day, simply because a government cannot default.
Rs 1,66,276 crore are just the projected losses of India’s public sector companies, for this year. Imagine, the kind of losses that have been accumulated over the years. Now imagine the kind of money that has been borrowed by these companies to keep running.

And now imagine, the kind of money that the government of India will have to provide in the years to come, to keep repaying these loans.

It’s a very scary proposition. And since, in the end, we are always asked, but what is the solution, let’s provide a solution, at least this time around. As Joshi said in his speech: “So far, successive Indian governments have been stuck with the fetish of 51 per cent ownership and have only flirted with the idea of privatization…It is high time the government grasped the nettle of mounting a substantial programme of privatization, at least of those PSEs that make losses or meagre profits… This gain could be used by the government to invest in socially beneficial activities that the private sector would normally avoid, such as rural roads and irrigation.”

But this is what we call an impossible solution. Joshi is not the first economist to have recommended the sale of public sector enterprises and the investment of the money thus generated into public goods. The government(s) have been in the know of this solution for a very long time, and have chosen to do nothing about it, up until now. And there is no reason for them to change that.

The column originally appeared in Equitymaster as on February 15, 2018.

Taxpayer Funded Bailouts of Public Sector Banks Will Only Get Bigger

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In the first column that we wrote this year, we said that even the Reserve Bank of India (RBI) is not sure of how deep the bad loans problem of India’s public sector banks, runs. And from the looks of it, the central bank has finally gotten around to admitting the same and doing something about it.

Up until now, the banks (including public sector banks) could use myriad loan restructuring mechanisms launched by the RBI and available to them, and in the process, postpone the recognition of a bad loan as a bad loan. Restructuring essentially refers to a bank allowing a defaulter more time to repay the loan or simply lowering the interest that the defaulter has to pay on the loan. Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more.

These mechanisms came under fancy names like the strategic debt restructuring scheme to the 5/25 scheme. Banks, in particular public sector banks, used these mechanisms to keep postponing the recognition of bad loans as bad loans. This allowed banks to spread out the problem of bad loans over a period of time, instead of having to recognise them quickly.

This has led to a situation where the bad loans of public sector banks in particular, and banks in general, have kept going up, with no real end in sight.

We have seen senior bankers say, the worst is behind us, for more than a few years now. And that is clearly not a good sign.

The bad loans of banks jumped to 10.2 per cent as on September 30, 2017, up by 60 basis points from 9.6 per cent as on March 31, 2017. One basis point is one hundredth of a percentage.

This basically means that for every Rs 100 that banks have lent, more than Rs 10 has been defaulted on by borrowers. The situation is worse in case of public sector banks. For every Rs 100 lent by these banks, Rs 13.5 has been defaulted on by borrowers. For private sector banks, the bad loans stood at 3.8 per cent.

This has led to the RBI, having to revise its future projections of bad loans, over and over again. In fact, in every Financial Stability Report, published once every six months, the RBI makes a projection of where it expects the bad loans to be in the time to come. And in every report over the past few years, this figure has been going up.

As the latest Financial Stability Report points out: “Under the baseline scenario, the GNPA ratio [gross non-performing assets ratio] of all scheduled commercial banks may increase from 10.2 per cent in September 2017 to 10.8 per cent by March 2018 and further to 11.1 per cent by September 2018.”

In the Financial Stability Report published in June 2017, the RBI had said: “Under the baseline scenario, the average GNPA ratio of all scheduled commercial banks may increase from 9.6 per cent in March 2017 to 10.2 per cent by March 2018.”

In June 2017, the RBI expected the bad loans figure in March 2018 to be at 10.2 per cent. Now it expects it to be at 10.8 per cent. This is an increase of 60 basis points. This revision of forecasts had been happening for a while now. This is a problem that needed to be corrected. The bad loans of Indian banks need to be recognised properly, once and for all. The farce of the bad loans increasing with no end in sight, needs to end.

Earlier this week, the RBI did what it should have done a while back. But, as they say, it is better late than never. India’s central bank has done away with half a dozen loan restructuring arrangements that were in place and which allowed banks to keep postponing the recognition of their bad loans as bad loans.

As per a notification issued on February 12, 2018, a bank has to start insolvency proceedings against a defaulter with a default of Rs 2,000 crore or more, if a resolution plan is not implemented within 180 days of the initial default. The banks will have to file an insolvency application, singly or jointly (depending on how many banks, the borrower owes money to), under the Insolvency and Bankruptcy Code 2016 (IBC) within 15 days from the expiry of 180 days from the initial default.

The resolution plan can be anything from lowering of interest rate, to converting a part of the loan into equity or increasing the repayment period of the loan. The banks have a period of 180 days to figure out whether the plan is working or not. If it is not working, then insolvency proceedings need to be initiated.

This particular change will not allow banks to keep postponing the recognition of bad loans, as they have been up until now. One impact of this move will be that the bad loans of public sector banks will shoot up fast in the near future. While that is the bad part, the good part is that now we will have a better understanding of how bad the bad loans problem of Indian banks really is. The farce of every increasing bad loans is likely to end quickly.

In addition to this, the notification has also asked the banks to report to the Central Repository of Information on Large Credits (CRILC), all details of borrowers who have defaulted and have a loan exposure of Rs 5 crore or more. This has to be done weekly, every Friday. This will give the RBI a better understanding of the bad loans problem. And with more information at its disposal, it will also be in a position to see, whether banks are recognising bad loans as bad loans, or not.

While this is a good move, it does not solve the basic problem of the public sector banks i.e. they are public sector banks. With these changes made by the RBI, the real extent of the bad loans problem is expected to come out. With more bad loans, more capital will have to be written off in the days to come. This means that the government, as the major owner of public sector banks, will have to infuse more capital into these banks, if it wants to maintain its share of ownership in these banks. And from the looks of it, there is no reason to suggest otherwise. This means that the taxpayer funded bailout of public sector banks, is likely to get bigger in the days to come.

As we have been saying for a while, the government only has so much money going around, and if the taxpayer funded bailouts of public sector banks bailout are likely to get bigger, that money has to come from somewhere.

Where will that money come from? The money will come from lesser government spending on agriculture, education, health etc. That is something which has been happening for the last few years. It will also come from more farcical decisions like LIC buying shares in other public sector enterprises, and companies like ONGC having to borrow money to buy a big stake, in companies like HPCL, with the overall government ownership not changing at all.

As we like to say very often, the more things change, the more they remain the same.

The column was originally published on Equitymaster on February 14, 2018.

Is Federal Reserve Getting Ready for an ‘Easy Money’ Confrontation with Donald Trump?

3D chrome Dollar symbol

We were at the Taj Mahal Hotel in Mumbai, attending the Equitymaster conference over the last two days. Overlooking the dark waters of the Arabian Sea and the Gateway of India, as we ate, talked and heard, we also sat back and thought about how the end of the easy money era would play out.

As we heard Marc Faber and Ajit Dayal lay out their ideas, we got more ideas. And we came to an old conclusion, all over again: forecasting, especially about the future, is a difficult business. But then someone’s got to take a shot at it. Everyone in the investing world cannot be cautiously optimistic. We have clearly have had enough of that term.

So how is this end of the era of easy money, likely to play out? The Federal Reserve of the United States, the American central bank, has started shrinking its massive balance sheet from October 2017 onwards. Between October 3, 2017 and January 29, 2018, the Federal Reserve has shrunk its balance sheet by around $40 billion, we can see that from the Fed documents. But there is still a long way to go, given that the size of the Federal Reserve’s balance sheet is still more than $4.4 trillion.

In the aftermath of the financial crisis that started in September 2008, once the Lehman Brothers, the fourth largest investment bank on Wall Street went bust, and many other financial institutions in the Western world almost went down with it, the Federal Reserve decided to print a lot of money. But just printing money wasn’t enough, this money, had to be pumped into the financial system as well.

This printed money (or rather created digitally) was pumped into the financial system by buying American treasury bonds and mortgage backed securities. American treasury bonds are bonds issued by the American government in order to finance its fiscal deficit, or the difference between what it earns and what it spends.

Mortgage backed securities are essentially securitised financial securities which are derived from mortgages (i.e. home loans). As of September 1, 2008, the Federal Reserve had assets worth $905 billion. As it got around to buying treasury bonds and mortgaged backed securities, it expanded its balance sheet very quickly. The size of Federal Reserve’s balance sheet peaked at $4.51 trillion, towards the end of December 2016.

The idea was that all this money floating around in the financial system would drive interest rates low and keep them there. This happened. Over and above this, the hope was that the companies would use low interest rates as an opportunity to borrow, invest and expand. This would create jobs and employment, would lead to spending and create faster economic growth.

The companies didn’t quite behave the way they were expected to. Yes, they did borrow. But they borrowed to buyback their shares and reduce the number of outstanding shares, and hence, pushed up their earnings per share.

These buybacks essentially benefitted the rich Americans who owned shares. The benefits were two-fold. First, they had an opportunity to sell their shares back to the companies buying them. And second, as the stock market rallied because of improved earnings and all the money floating around, those who owned shares benefitted.
But this wasn’t really what the Federal Reserve had hoped. The consumers were also supposed to borrow and spend at low interest rates. But that didn’t quite play out the way the Federal Reserve had hoped.

What happened instead was that large financial institutions borrowed money at very low interest rates and invested them in stock and bond markets all over the world, including India. These trades are referred to as the dollar carry trade. This led to stock markets rallying all over the world, irrespective of the fact whether the earnings of the companies were improving or not.

The Federal Reserve has decided to gradually start withdrawing all the money that it has put into the global financial system. Between October and December 2017, it planned to sell treasury bonds and mortgage backed securities worth $10 billion. Between January and March 2018, this will go up to $20 billion a month. Between April and June 2018, this will go up to $30 billion a month. Between July and September 2018, the Federal Reserve plans to sell bonds worth $40 billion a month. After that the amount will rise to $50 billion a month.[i]

How does the actual evidence look like? As mentioned earlier in the piece, the Federal Reserve had managed to shrink its balance sheet by $40 billion between October 3, 2017 and January 29, 2018. From the looks of it, the Federal Reserve seems to be doing what it said it would do. Nevertheless, these are early days.

In 2018, the Federal Reserve is expected to shrink its balance sheet by $420 billion and 2019 onwards, the balance sheet is expected to shrink by $600 billion a year. With the Federal Reserve taking money out of the financial system, there will be lesser money going around, this is likely to push up interest rates. In fact, the yield (i.e. return) on the 10-year treasury bond has crossed 2.85%. This yield acts as a benchmark for other kinds of lending, simply because lending to the American government is deemed to be the safest form of lending. With interest rates expected to go up, the carry trades are expected to become unviable. This will lead money being withdrawn from stock and bond markets all over the world.

In fact, regular readers would know that we have already discussed a large part of what has been written up until now. But now comes the completely crazy part. The United States government is expected to borrow $955 billion, during the course of this year, to meet its expenses. It is further expected to borrow a trillion dollars, in each of the next two years. Basically, the American government needs to borrow close to $3 trillion between 2018 and 2020.

During the same period, the Federal Reserve is working towards withdrawing more than $1.6 trillion ($420 billion in 2018 + $600 billion in 2019 + $600 billion in 2020) from the financial system. In this scenario, when the Federal Reserve is withdrawing money from the financial system and the government needs to borrow a huge amount of money, it is but logical that the interest rates in the United States are going to go up.

This will impact the carry trades. Hence, stock markets and bond markets will have a tough time all over the world. Of course, all this comes with the assumption that the Federal Reserve will continue doing what it is. The question is will it continue to withdraw the printed money it has pumped into the financial system?

Now this is where things get really interesting. The American society as a large is a highly indebted one. The total household debt of the Americans as of September 30, 2017, stood at $12.96 trillion. The debt has been going up for 13 consecutive quarters now. This debt includes, home loans, auto loans, student loans, credit cards outstanding, etc.
Hence, rising interest rates will hurt the average American as the EMIs will go up. It will also hurt the American government which is in the process of borrowing more, in the years to come. Governments, because they borrow as much as they do, as a thumb rule, like low interest rates.

In this scenario, if the Federal Reserve continues withdrawing the printed money, it is more than likely to run into a confrontation with the American president Donald Trump. Trump has only recently chosen Jerome Powell as the Chairman of the Federal Reserve, after Janet Yellen. One school of thought seems to suggest that Powell, given that he has been appointed by Trump, is likely to bat for Trump and go easy on withdrawing money from the financial system, and allowing interest rates to go up. But it is not just up to him. The American monetary policy is decided by the Federal Monetary Policy Committee (FOMC), which has Powell and 12 other members.

In fact, even if that Powell does not bat for Trump, the FOMC might still vote to go slow on allowing interest rates to rise. Ultimately, the Federal Reserve has to ensure that the American economy continues to remain on a stable footing. If rising interest rates end up hurting the American economy, the FOMC will have to react accordingly. No Federal Reserve decisions are written in stone and can always be changed.

The question is how quickly is this likely to happen? Now that is a very difficult question to answer. But my best guess (and I use the word very very carefully here) is that during the second half of the year, the Federal Reserve might have to reverse its policy of taking out all the money that it has put into the global financial institution.

Up until then, a lot of damage will be done to the stock and bond markets around the world. The funny thing is that though the Federal Reserve is now pulling out money to let interest rates rise, the European Central Bank continues to buy bonds issued by its member governments and the 10-year government bond yields of European countries, is significantly lower than that of United States.

What does this mean in an Indian context? Unless, the American Federal Reserve reverses its current policy, the Indian stocks are going to have a tough time. That is a given. What happens next, if and when Federal Reserve changes track? Will another easy money start? On that your guess is as good as ours.
Let’s watch and wait!
[i] https://www.federalreserve.gov/newsevents/pressreleases/monetary20170614a.htm

The column originally appeared on Equitymaster on February 12, 2018.

One Learning from Economic Survey: India’s Future is Pakodanomics

One issue that I have regularly written and discussed in my columns is India’s investment to gross domestic product (GDP) ratio, which has fallen dramatically over the years. The latest Economic Survey gets into great detail regarding this issue and paints, what I would call a very bleak picture of India’s economic future.

India’s investment to GDP ratio “climbed from 26.5 percent in 2003, reached a peak of 35.6 percent in 2007, and then slid back to 26.4 percent in 2017.” This is a huge fall of 9.2 per cent from the peak.

As the Economic Survey points out: “And while it is true that the past 15 years have been a special period for the entire global economy, no other country seems to have gone through such a large investment boom and bust during this period.”

Why has this dramatic fall in investment as a proportion of the overall economy happened? This is something that has been analysed to death. Nevertheless, as the Survey points out: “India’s investment slowdown is unusual in that it is so far relatively moderate in magnitude, long in duration, and started from a relatively high peak rate of 36 percent of GDP. Furthermore, it has a specific nature, in that it is a balance sheet related slowdown. In other words, many companies have had to curtail their investments because their finances are stressed, as the investments they undertook during the boom have not generated enough revenues to allow them to service the debts that they have incurred.”

It is well known that companies tend to invest and expand when they are unable to meet the demand from their current production capacity. The Reserve Bank of India carries out capacity utilisation surveys of manufacturing firms every three months. The latest survey for the period April to June 2017, found that capacity utilisation stood at 71.2 per cent. In fact, capacity utilisation has varied between 70 and 72 per cent for a while now.

As economist Madan Sabnanvis writes in his new book Economics of India-How to Fool all People for all Times: “The capacity utilisation rate has gotten stuck in the region of 70-72 per cent which means two things: first demand is absent, and second, even if it does increase, production can be scaled up without going in for fresh investment.”

While, it is easy to hope that this is something that can be unravelled, history tends to suggest otherwise. The Economic Survey looks at many other countries which, in the past, have gone through what India is currently going through on the lack of investment front. The Survey specifically looks at “cases in which the rate of investment has fallen by at least 8.5 percentage points from its peak over a 9 year period are considered.” It then goes on to find out, “what is the investment rate 11, 14 and 17 years after the peak?”

The results are far from encouraging. As the Survey points out: “Investment declines flowing from balance sheet problems are much more difficult to reverse. In these cases, investment remains highly depressed, even 17 years after the peak… India’s investment decline so far has been unusually large when compared to other balance sheet cases.”

The Survey further points out: “The median country reverses only about 25 percent of the decline 14 years after the peak, and about 40 percent of the decline 17 years after the peak.” This conclusion is based on a sample of 30 countries where the investment to GDP ratio fell by 8.5 per cent from its peak, over a 9-year period. As we have seen earlier, the investment to GDP ratio in the Indian case fell from a peak of 35.6 per cent in 2007 to 26.4 per cent in 2017.

The data points stated above do not give us much hope. It basically means that over a period of 11 years after the investment to GDP ratio peaked, the median country in the sample tends to improve its investment to GDP ratio by 2.5 per cent from the lowest level achieved. As the Survey points out: “A ‘full’ recovery is defined as attainment of an investment rate that completely reverses the fall, while no recovery implies the inability to reverse the fall at all or worse.”

The trouble is in the Indian case, more than a decade has elapsed, and the investment to

GDP ratio has continued to fall.

Take a look at Figure 1.

Figure 1: Count and Extent of Recovery from India-Type Investment Decline*Note: *T is the peak time Period *: A fifty percent recovery implies that the country attained an investment rate that reversed half of the 8.5 percentage point fall. The dots imply the percentage of the total fall that the median country namaged to reverse.

Figure 1, basically points out that over a period of 17 years after the investment to GDP ratio peaked, 10 out of the 28 countries were able to make a recovery of more than 50 per cent. Given that the Indian investment to GDP ratio has continued to fall, this does not give us too much hope. Despite this large fall in investment, India has had to pay a moderate cost in terms of growth. As the Survey points out: “Between 2007 and 2016, rate of real per-capita GDP growth has fallen by about 2.3 percentage points-that is lower than the above 3 percent decline in growth noticed, on average, in episodes in other countries that have registered investment declines of similar magnitudes.”

It is a given that unless this investment slowdown reverses at a very rapid rate, India’s hopes of providing jobs and decent employment opportunities, to a million Indians who are entering the workforce every month and the 8.4 crore Indians who need to be moved out of agriculture to make it economically feasible, remains just that, a hope.

India’s hopes of a double digit economic growth, also remain just a hope. As the Survey points out: “A one percentage point fall in investment rate is expected to dent growth by 0.4-0.7 percentage points.”

What does the Economic Survey think India’s chances are? “India’s investment decline seems particularly difficult to reverse, partly because it stems from balance sheet stress and partly because it has been usually large. Cross -country evidence indicates a notable absence of automatic bounce-backs from investment slowdowns. The deeper the slowdown, the slower and shallower the recovery,” the Survey states.

But given that it is a government document, it ends on a note of hope. “At the same time, it remains true that some countries in similar circumstances have had fairly strong recoveries, suggesting that policy action can decisively improve the outlook,” the Survey states. While this sentence suggests hope, there is nothing in the analysis carried out in the Economic Survey, which gives any hope.

The trouble is that the policy action has had next to no impact on the investment to GDP ratio for more than a decade now. The ratio has simply continued to fall.

So, what does that leave us with? Without an increase in investment there will be very few jobs and employment opportunities being created. Basically, any industry that is set up in any area, first provides jobs to people who work for it. It also creates jobs for the ancillary industries which feed into it. Over and above this, it creates other employment opportunities in the area.

When the IT industry took off in and around Bengaluru, other than providing jobs to engineers, it provided employment opportunities for drivers, cooks, maids, shop keepers, and so on. At the second level, as the engineers earned more, and demanded good residential spaces to live in, it created demand for builders. That in turn created employment opportunities in the construction and the real estate industry. And so cycle worked.

To conclude, the question is what will feed India’s huge demographic dividend of one million youth entering the workforce, every month, if investment doesn’t take off? The only answer right now is: Pakodanomics.

And to distract attention from Pakodanomics, given that it is not a great way to make a living, we will keep having more and more Padmavats, for distraction.

(You can read in detail about pakodanomics here and here).

The column was originally published in Equitymaster on January 30, 2018.

Why Pakodanomics is Not the Answer to Creating Employment

narendra_modi

India gave the world zero, and helped Mathematics, which until then was dependent on Roman numerals, leapfrog.

Last week we also gave the world, what I would like to call pakodanomics (I guess even bondanomics would work fine).

In a television interview, prime minister Narendra Modi, said: “If someone opens a ‘pakoda’ shop in front of your office, does that not count at employment? The person’s daily earning of Rs 200 will never come into any books or accounts. The truth is massive people are being employed.”

Thus, prime minister Modi, helped found a new discipline in economics, pakodanomics.

What was prime minister Modi really trying to say here? This entire jobs crisis is being overblown. What is important is employment and not jobs. This, I think, is a fair point, which most people in India do not get, given our fascination for sarkari (i.e. government) jobs. Of course, expecting the government to create employment for one million Indians entering the workforce every month and the 8.4 crore Indians who need to be moved from agriculture to make it economically feasible, is unfair. That point is well taken.

Employment can come in various forms. Even selling pakodas and making Rs 200 per day is employment. Selling pakodas on the street is incidental here. What is more important is that the prime minister of India is saying that people can sell stuff on the street, make money and employment can thus be generated.

There is a basic problem with this argument. Before I get into explaining that problem, a couple of clarifications: a) I didn’t come up with the example of the selling pakodas, the prime minister did. b) The piece is not about the unit economics of pakodawallahs and how much money they make on a given day (I know, dear reader, you know a pakodawallah who is a millionaire). But it is about selling any product on the street to earn Rs 200 per day and the prime minister of our country offering this as an employment opportunity.

At Rs 200 per day, the annual income of an individual selling pakodas (Again, let me repeat here, pakodas are incidental to the entire example. It is about making money by selling stuff on the street) would be Rs 73,000 (Rs 200 x 365 days). This is assuming that he sells 365 days a year. This is an unrealistic assumption, but we will let it be.

The per capita income of an average Indian was Rs 1.03 lakh in 2016-2017. Hence, the individual selling pakodas earns 29 per cent less than the average Indian. If I were to flip this point, an average Indian makes 41 per cent more than the individual selling pakodas. So, clearly there is a problem.

Of course, someone has to earn lower than the average income. But the difference between the average income and the income of the individual selling pakodas is significant. PM Modi’s pakoda seller is not earning much simply because there are too many people out there selling pakodas. At a broader level there are too many Indians selling stuff on streets. This is primarily because there aren’t proper jobs going around. And if there are, people are unskilled to carry them out.

Let’s get into a little more detail by looking at some data. Take a look at Table 1, which deals with the self-employed people in India.

Table 1: Self Employed / Regular wage salaried / Contract/ Casual Workers
according to Average Monthly Earnings 

What does Table 1 tell us? It tells us that nearly half of India’s workforce (46.6 per cent to be exact) is self-employed. Further, 67.5 per cent of India’s self employed make up to Rs 90,000 a year. A little over 41 per cent make only up to Rs 60,000 a year. What does this tell us? It tells us very clearly that self-employment (selling pakodas for example) does not pay well.

Most of India’s self-employed workers make lesser money per year than the average per capita income of the country, which in 2015-2016 (for which the self-employed data is), was Rs 94,130. So, there is a clearly a problem with being self-employed. (The good part is, it is better than being a casual labourer, which is by far worse. But to be self-employed you need some basic capital to start, which many Indians, who end up as casual labourers, don’t).

People in India are self-employed because they do not have a choice. Currently, the government is busy trying to pass of self-employment in India as entrepreneurship, which are two very different things. People in India become self-employed because there are no jobs going around for them. Entrepreneurship, on the other hand, is by choice.

Further, as can be seen from Table 1, getting a job is more monetarily rewarding than being self-employed. Hence, selling pakodas or being self-employed, is not the solution to the problem. It is a symptom of the problem, an indication of the problem and the fact that barely anything is being done about it.

To conclude, zero was a useful invention, pakodanomics isn’t. It’s better to get rid of it as soon as possible and concentrate on the real problem of creating the right environment which will help the real entrepreneurs create genuine employment opportunities for India’s youth.

As I keep saying, the first step towards solving a problem is recognising that it exists.

The column originally appeared in Equitymaster on January 24, 2018.

India’s Jobs Problem: No One Sells Pakodas In Front of Your Office?

So, India does not have a jobs problem. We are generating enough jobs and everybody is living happily ever after.

Or so seems to suggest a new study carried out by Soumya Kanti Ghosh, Chief Economic Adviser at the State Bank of India and Pulak Ghosh, a Professor at IIM Bangalore. The study uses data from Employees Provident Fund Organisation (EPFO).

In a column in The Times of India, the authors write: “Based on all estimates, we believe that 7 million formal jobs are being added to payroll on a yearly basis.”

This new study has caught the imagination of the media and the politicians in power and is being flagged all around. If seven million jobs are being created in the formal sector every year, India does not have a jobs problem. The informal sector does not have to register with the EPFO. Informal sector is that part of the economy which is not really monitored by the government and hence, it is not taxed.

The informal sector in India, up until now, has been creating a bulk of the jobs. There are various estimates available on this. Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital wrote in a recent research note: “India’s informal sector is large and labour-intensive. The informal sector accounts for ~40% of India’s GDP and employs close to ~75% of the Indian labour force.”

The Institute for Human Development, India Labour and Employment Report, 2014, points out: “An overwhelmingly large percentage of workers (about 92 per cent) are engaged in informal employment and a large majority of them have low earnings with limited or no social protection.”

As the Economic Survey of 2015-2016 points out: “The informal sector should… be credited with creating jobs and keeping If unemployment low.” If seven million jobs are being created just in the formal sector, imagine what must be happening in the informal sector. Firms and individuals operating in the informal sector, must be falling over one another to recruit people for jobs they have on offer. But is that really happening?

As I have mentioned in the past, 12 to 15 million Indians are entering the workforce every year. And given that seven million jobs are being created just in the formal sector, the individuals currently entering the workforce must be having a ball of a time, with so much to choose from.

Of course, all this goes against what I have been writing all along about India having a huge jobs problem and the fact that India’s so called demographic dividend is being destroyed. But it also goes against a lot of other data that is on offer.

Jobs are created when companies invest and expand. Let’s first look at the investment to gross domestic product (GDP at constant prices) ratio of the Indian economy. This ratio as I have written in the past has been falling for a while now. Take a look at Figure 1:

Figure 1: 

As is clear from Figure 1, investment as a part of the overall economy (represented by the GDP) has been falling over the years. How are seven million jobs being created in this scenario? In fact, let’s take a look at the incremental investment to incremental GDP ratio, over the years, in Figure 2. This basically plots the ratio of the increase in investment during the course of a year, against the increase in GDP during that year.

Figure 2. 

The incremental investment to incremental GDP Ratio between 2013-2014 and the current financial year (2017-2018) has varied between 8-25 per cent. India seems to have discovered a new economic model of creating jobs without a pickup in investment, i.e., if seven million jobs are indeed being created every year.

Companies tend to expand when they are unable to meet the demand from their current production capacity. The Reserve Bank of India carries out capacity utilisation surveys of manufacturing firms every three months. The latest survey for the period April to June 2017, found that capacity utilisation stood at 71.2 per cent. In fact, capacity utilisation has varied between 70 and 72 per cent for a while now.

As economist Madan Sabnanvis writes in his new book Economics of India-How to Fool all People for all Times: “The capacity utilisation rate has gotten stuck in the region of 70-72 per cent which means two things: first demand is absent, and second, even if it does increase, production can be scaled up without going in for fresh investment.”

The question is how are jobs being created without expansion?

In fact, the data from Centre for Monitoring Indian Economy suggests that new projects announcement in the period of three months ending December 2017, came in at a 13-year low. Take a look at Figure 3.

Figure: 3 

The new investment projects announced during the period of three months up to December 2017, were the lowest since the period of three months ending June 2004. This is a clear indication of the fact that the industry is not betting much on India’s economic future because if they were they would be expanding at a much faster rate and announcing more investment projects than they currently are.

The industrialists may say good things about India in the public domain and in the media, but they are clearly not betting much of their money on the country. And this brings us back to the question, if the industry is not investing, how are jobs being created?

Let’s take a look at the money lent by banks to industry, in Figure 4.

Figure 4: 

The bank lending to industry has been falling over the years. In fact, lately, it has been in negative territory, which means that the overall bank lending to industry has contracted.

This means that on the whole, banks haven’t lent a single new rupee to industry, lately. And that is another good example of industries not expanding. This brings us back to the question: how are seven million formal jobs being created then?

One argument that can be offered against Figure 5 is that over the years many corporates haven’t been borrowing from banks to meet their funding needs. This is true. But this is largely limited to large corporates. Global experience suggests that jobs are actually created when micro, small and medium enterprises expand, and become bigger. In order to do that, they need to borrow.

How does the scene look when we leave out large corporates? Let’s take a look at Figure 5.

Figure 5: 

Bank lending to micro, small and medium enterprises, has been in negative territory for a while now. This basically means that the overall lending to these enterprises has contracted and not a single new rupee has been lent by banks to these firms. How are these firms investing and expanding and creating jobs?

Of course, manufacturing is not the only sector creating jobs. The services sector creates a huge number of jobs of India. One of the biggest job creators in the services sector are real estate companies, which are currently down in the dumps. The construction sector is also a heavy job creator, but with real estate being the way it is, construction is not doing too well either. The information technology sector is looking to shed jobs at the lower end, with robots taking over. Tourism was never a heavy employer of people, in the formal sector, which is what we are talking about here.

Arvind Panagariya, who was the vice chairman of the NITI Aayog, until August 2017, maintained during his tenure, that India was not creating jobs, because India’s entrepreneurs were not investing in labour intensive activities.

In fact, on August 25, 2017, a few days before his tenure ended, Panagariya said“The major impediment in job creation is that our entrepreneurs simply do not invest in labour intensive activities.”

This becomes clear from India’s exports. If one looks at labour intensive exports like textiles, electronic goods, gems & jewellery, leather and agriculture, exports have more or less remained flattish over the last few years. (For a detailed exposition on this, you can click here). So, how are jobs being created with exports remaining flat in labour intensive sectors? Further, if we do believe that seven million jobs are being created every year, then was one of the main economic advisers to the prime minister, wrong all along?

Also, if so many jobs are being created, why does India have so much underemployment. Take a look at Table 1.

Table 1: Percentage distribution of persons available for 12 months based on UPSS approach 

What does Table 1 tell us? It tells us that in rural India, only 52.7 per cent of the workforce which was looking for work all through the year, actually found it. 42.1 per cent of the workforce found work for six to 11 months. If there are so many jobs being created, why are these people finding it difficult to find work all through the year, is a question worth asking. Further, if so many people are finding jobs, why has economic growth slowed down over the years. Are these people earning and not spending money? Also, if there are so many jobs going around, why have the land-owning castes across the country been protesting and demanding reservations in government jobs. Is there an explanation for that?

In the end, there is way too much evidence against not enough jobs being created. Trying to brush that aside, on the basis of a shaky study, will do the nation way too much harm. As I keep saying, the first step towards solving a problem is acknowledging that it exists, otherwise there are enough people selling pakodas, bondas, sandwiches, timepass and what not, outside our offices. But that doesn’t really solve the problem.

Postscript: In order to understand the basic methodological flaws in the study carried out by Ghosh and Ghosh, I suggest you read this.

In order to understand the basic problems in using EPFO data to estimate jobs, I suggest you read this.

The column originally appeared in Equitymaster on January 22, 2018.