Thursday, January 17, 2013

IMF's comments on the Indian Regulatory System

The IMF has recently released the India: Financial System Stability Update. While commending on the fact that the system has a tightly controlled regulatory and supervisory regime and is reasonably resilient with no likelihood of near time stress recommends certain actions, some of which merit some thought - while others are merely incremental in nature.

a) That the regime for large exposures and connected lending needs tightening in line with good international practice. The report points to the fact that the maximum level permissible at a group level including lending for infrastructure is high at 50% of bank's capital and that it needs to be reduced to 10-25% in line with international practises. While this can be a goal post over a long time period, reducing the limit steeply will reduce availability of finance to some sectors. The solution to this could be development of alternate markets for financing which will temper , if not reduce significantly , the requirement of bank finance.

b) Reducing SLR holding limits : While appreciating the fact that CRR and SLR requirements help ensure liquidity availability during crises, IMF recommends reduction in SLR holdings in Goverment Securities. The recommendation, to my mind, comes from IMF's observation of the unsavory experience with the European banks which have held large investments in Government Bonds. This recommendation fails to take into cognizance the fact in general the G Sec investment holdings in most banks is significantly higher than the mandated requirement, which in any case is being lowered in a slow manner. This also fails to take into consideration that what is held by Indian Banks is national debt ( not international debt as in the case of most European banks)and the Debt to GDP ratio of India is better than its European counterparts. Any risk of sovereign default is hence far fetched. There is also no reason to believe that reduction in SLR norms will lead to improvement in the Corporate bond market (which acceptably has to develop in the country), as what matters is the levels of government borrowings.

c) RBI nominees on PSB Boards may lead to conflict of interest: While the recommendation in theory is probably correct, the fact is that the presence of a RBI nominee helps the regulator to get information on a real time basis and thus help in supervision. It also helps act as a deterrent , preventing activities that may be inimical to the bank and the system at large. Considering the pros and cons, RBI would do well to retain this system or retain the right to use this option.

d)Insolvency framework businesses and more particularly for proprietorship firms - which are the majority businesses in the country. The amendments to the Company's Act, which provide for OPC (One Person Company) will largely address this issue.

e) International and domestic supervisory information sharing : This is being addressed by RBI considering supervisory colleges for particularly large banking organizations. RBI has already set up supervisory colleges for SBI and ICICI Bank which have significant international presence.

The report indicates that the Indian regulatory system is clearly in good shape and while being structured to suit Indian needs meets international requirements in most cases - and what will work is independent and tight regulation. 'Gaps' (if one may say so) which are there are either by design or are already being worked on. The recent crisis has exposed the weaknesses of the neo-liberal light regulatory framework that was championed by developed nations and the Bretton Wood Twins. And as they say, it is only when the tide goes down, that we know who has been swimming naked. IMF's commendation is this context is hence an interesting development.

Monday, January 14, 2013

Bending back to please - Deferring the GAAR

As expected, the Government has deferred implementing the General Anti Avoidance Rules by two years - in a bid to 'allay fears of foreign investors and boost sagging FDI inflows'. The Deputy Chairman of the Planning Commission says that this 'will boost the investment climate'

The implication is that FDI inflows have been / are structured to avoid tax payments. It also implies that tax avoidance - the Mauritius route etc is viewed in a benign fashion , while the honest tax payer is penalized. This kind of economic policy making hurts.

Justice J S Verma's observation on the SC judgement in the Vodafone case clearly stresses this point . He says "The effect of benefiting a corporate is to cast a higher tax burden on the common man and when you uphold an illegal tax avoidance, then you cast a higher tax burden on the honest tax payer". True.

While the markets gave a thumbs up with the Sensex gaining 240 points, what is still not clear is how postponement of GAAR will boost sagging FDI inflows. It is not that there is a long queue of investors dying to invest in India and wanting only this change to be done. And notwithstanding what the western schooled economists say, it is plain common sense that FDI is no panacea for economic evils in this country and so, the question is whether the Government needs to bend back to please.

What Price - Price WaterHouse ?

About a decade back, Global Trust Bank used to be audited by Lovelock and Lewes (L&L). The audit firm declared the bank a going concern and raised no objection to the (gross under) reporting of NPAs by the bank. Following the aborted attempt to merge with the then UTI Bank ( now Axis Bank), media was awash with the terrible state of GTB's asset book. On RBI's diktat, GTB changed its auditors .... it took PWC as its auditors. Some how, everybody missed the fact that L&L and PWC were just two arms of the same group. L&L was PWC's sister concern...they call it 'network firm'. And what happened to GTB is something we know.

About half a decade back, Satyam Computers used to be audited by PWC...( well... Ramesh Rajan from PWC says it was Lovelock and Lewes and that the fee deposited by Satyam Computers to PWC was transferred to L&L !) ...the creative internal accounting these firms follow is immaterial. What happened in Satyam Computers is something we know.

And now, PWC is back in the news. The IT Dept says, the firm advised Nokia on what it considers a Rs 2500 Cr tax evasion. They have 'missed' claiming TDS on their payments to their parent company.

It is PWC again and again. In the first two cases the shareholders lost heavily and in the third - the Government has (atleast till now). PWC is still a 'respected international audit firm'.

The problems are basic and pertain to conflict of interest.

a) The audit firm also doubles up as a tax consultant ( Well, some of them don't do it directly - they have 'network' firms to do it for them ).

b) The audit firm is supposed to give an opinion on the accounts of a company - basically the results of performance of the managers and promoters to the shareholders - but are paid by the managers.

And till we resolve these issues, there will be managers in firms who will be willing to pay a price and price waterhouses which will sell themselves...

Tuesday, January 8, 2013

Forcing policy changes by threat

Fitch Ratings , the international rating agency has reiterated its negative outlook for India and has warned of a downgrade. The agency complains that structural reform process is sluggish. This is the era of policy making by threat. The agency is concerned over
a)India's economic and fiscal outlook
b)Sharp slowdown in growth
c)persistent inflationary pressures
d)weaker public finances.

Probably these are concerns, but should the government choose to cut back spending to ensure that the fiscal deficit is contained, it will impact the already fragile recovery , and should the central bank increase rates to cut out inflation, it will affect growth. Less taxes may help growth, but will increase the deficit. Cut rates to spur growth and you have the threat of inflation picking up again. Look anywhich way, the Goverment cannot really do much. And this is after the spate of 'actions' taken by the Government.The fact is that we will need to live with this situation till global growth rates pick up. What the agencies would desire is a cut in subsidies (which is only huge in absolute amounts - in relative terms it is not really as big a problem as it is potrayed to be), lowering of taxes and a cut in rates. They forget that this country has a population of 1.2 billion and all that we have been taking in terms of growth has not been very inclusive. NSSO data clearly shows that the growth has not resulted in increased employment - it is a jobless growth.These policy prescriptions by Fitch or S&P will only aggrevate the problem. Running a country is not like running a company. And that is where the problem is.

Ratings are statements of opinions and the track record of thees agencies in rating corporate bonds is decent. What is questionable is their ability to rate other issues (their track record in rating mortgage backed securities is disastrous) and sovereigns. Sovereign debt rating is almost entirely unsolicited and the ratings and policy prescriptions of the three big agencies Fitch Ratings, S&P and Moodys has played a major role in accentuating the EU crisis, forcing governments to consider placing curbs on the timings of release of such un-solicited ratings and curbing ownerships. There is nothing to prove that these agencies have been successful in predicting crises.

What happens is that rating changes affects the ownership pattern of sovereign bonds - as most institutions. Because most institutions have allocations for bond holdings based on the ratings of the bonds, when a downgrade happens, it results in a huge sell off.... well that is what is supposed to happen in theory. But when US had its AAA ratings stripped, its bonds rallied ! Bloomberg reports that 'Predicting the consequences of a rating change by S&P or Moody’s may be little better than flipping a coin, with yields moving in the opposite direction than suggested 47 percent of the time, according to data compiled by Bloomberg in June on 314 upgrades, downgrades and outlook changes going back to 1974'....

So should the Government worry ? Reforms are required. But we should make haste slowly. Policy should not be made under threat.