It isn’t enough to focus on Doing Business rankings

Mint, October 12, 2016

The Indian government has taken great interest in addressing the problems of doing business in the country and improving India’s rank in the World Bank’s “Doing Business” report. One parameter evaluated in this report is “resolving insolvency”. India ranks 136 in the world in the ease of “resolving insolvency” and 130 overall. The enactment of the Insolvency and Bankruptcy Code (IBC), 2016 is likely to change this. The formal resolution process laid out in IBC is a significant improvement on current procedures. Passing the law is a big step forward. It will result in the ancillary benefit of improving India’s score in the Doing Business report but in and of itself, it will not create a framework for effective insolvency resolution in India. The key now is implementation and this will require time, planning and building adequate State capacity.

The “Doing Business” rankings reflect a de jure approach of evaluating what should happen under the stated law, as opposed to what happens in practice. The “resolving insolvency” parameter in the report consists of two indicators: the “recovery rate” and “strength of insolvency framework index”. The “strength of insolvency framework index” is calculated based on the provisions of the law. It analyses the strength of the legal framework applicable to insolvency proceedings and tests whether a country has adopted internationally recognized good practices in the area of insolvency resolution.

The “strength of insolvency framework index” is the sum of four component indices. Each component index in turn consists of sub-components ranked on a scale of 0-1. The overall index is measured on a scale of 0-16, with cumulative scores across 16 sub-components.

A simple calculation based on the provisions of IBC shows that the enactment of the law can improve India’s “strength of insolvency framework” index from 6 to 12 (see table). The corresponding score for OECD (Organisation for Economic Cooperation and Development) high-income countries is 12.1. This will place India ahead of developed economies such as Canada, France, Hong Kong, New Zealand, Netherlands, Norway, Singapore, and the UK, emerging economies such as China, Colombia, Indonesia, Malaysia, Mexico, Peru, Russia, Thailand, Turkey and Vietnam, and on a par with Australia and Sweden. This improvement will come about merely because the law has been passed, even though it has not been implemented yet.

The other element of the “resolving insolvency” parameter is “recovery rate”. This is assessed through questionnaires filled out by insolvency professionals. The questions are based on a case study such as insolvency resolution of a limited liability company in a big city. It will be interesting to see how India’s estimated “recovery rate” changes now that IBC has been enacted, given that the industry of insolvency professionals is yet to take off. Any case study should not take into account a law that has not yet been implemented.

Many times in economic measurement, we can observe the de jure status, but what really matters is the de facto outcome. This distinction is important when using the “Doing Business” scoring. In a recent paper (2015), Mary Hallward-Driemeier and Lant Pritchett, show that there is no correlation between the findings recorded in the “Doing Business” report and the ground realities of doing business. Large gaps often exist between laws and regulations on paper, and the manner in which these are enforced, especially true of developing countries.

For instance, one of the questions asked in the World Bank questionnaire is: Does the insolvency framework allow a creditor to file for the insolvency of the debtor? The answer to this is “Yes” based on the IBC provisions. In reality, the filing process may be cumbersome in the absence of a good enabling infrastructure. This may distort creditors’ incentives to trigger insolvency proceedings. These issues are ignored because of the way the question is designed.

Successful implementation of IBC is contingent upon four institutional pillars: a private competitive industry of information utilities, a private competitive industry of insolvency professionals, effective adjudication infrastructure and a well-functioning regulator. While the law has proposed setting up this infrastructure, the related provisions lack clarity and are often inadequate. For example, one strength of IBC is that it specifies finite timelines for completing various stages of the resolution process. This needs an efficient judicial infrastructure. But the law itself is silent on what is needed to set up this institutional pillar.

Excessive focus on a de jure ranking may divert attention from what is needed now, which is proper implementation of the law. Energy and resources need to be devoted to a full-fledged implementation plan that involves creating good institutions and building adequate State capacity. If getting a higher rank on the “Doing Business” report were the sole objective, cosmetic changes to the Companies Act, 2013 would have sufficed.

The success of the bankruptcy reforms should be measured by well-defined outcomes in the context of credit market development. The specific outcomes to look out for are higher values of leverage, financial debt share in total debt, non-bank debt share in financial debt and share of unsecured borrowing in total debt. These are the metrics against which the success of IBC should be assessed—not the “Doing Business” ranking.

Clear the air before enforcing Bankruptcy Code

Business Standard, October 9, 2016 (with Anirudh Burman)

The Insolvency and Bankruptcy Code (IBC), 2016 proposes to set up new institutional pillars to support the insolvency resolution and liquidation processes. One such pillar is the industry of insolvency professionals. Insolvency professionals (IP) are expected to play a critical role in the timely and efficient insolvency resolution of firms and individuals. Two specific provisions pertaining to IPs in the new law have gone largely unnoticed: (i) not just individuals but firms can also get licensed as IPs (ii) those residing outside India can practise as IPs on Indian corporate and individual insolvency-related matters. Both these provisions can have important implications for the regulatory structure of the IP industry once the law is implemented.

The regulation of professions in India has been a failure. Self-regulatory organisations in professions such as medicine (Medical Council of India), law (Bar Council of India) and accountancy (The Institute of Chartered Accountants of India) have consistently failed to enforce good standards. This hurts the interests of consumers availing the services of the professionals. IBC has stepped away from this status quo. IBC has proposed a system of multiple, private self-regulatory organisations called IP agencies or IPAs that will regulate the insolvency professionals. The IPAs will compete with each other on entry barriers, codes of conduct and supervisory framework. Imagine that instead of the current monopoly, there are two Bar Councils of India competing with each other to prove that they have the better lawyers as their members.

The proposed IP regulatory structure is largely similar to that of stock market brokers - perhaps the only success story in India in regulation of professions. The brokers are members of the exchanges, BSE and NSE who in turn are regulated by the Securities and Exchange Board of India. In case of IBC, the IPs will be registered members of the IPAs. The IPAs will have regulatory and supervisory powers over their member IPs. The Insolvency and Bankruptcy Board of India (IBBI) will watch over the IPAs as well as the IPs.

In this framework, the regulatory burden on the IPAs (and also on the IBBI) will be significantly higher when the IPs are firms instead of individuals. Given the critical role played by IPs throughout the insolvency resolution and liquidation processes, they must be held accountable for their conduct and performance. Holding an individual accountable is easier than holding a corporate body accountable. Every IPA will need to have adequate capacity to regularly monitor, inspect and supervise the firms licensed as IPs. This will also have an impact on the business model of IPAs.

Canada is one of the few countries that allows firms well as individuals to be licensed as IPs. They do so by placing different entry and compliance requirements on firms compared to individual IPs. The insolvency regulator in Canada has issued clear and detailed directives on the eligibility criteria for licensing corporate IPs (or trustees in their case) and individual IPs, and on the organisational structure of firms applying for an IP licence. For instance, a majority of the directors and a majority of officers of the corporate trustee must also be individually licensed as trustees.

This raises several open questions with regard to this specific provision in IBC. What will be the corporate structure of a firm licensed as an IP under the new law? Unlike other Indian laws on professionals, the IBC mandates a qualification exam for IPs. Will all the employees of a corporate IP need to pass the exam or will it suffice if the directors or partners of the firm alone are licensed IPs? When an insolvency resolution case is given to an IP from such a firm, will the name of the IP go in the records or the name of the firm? This also relates to the accountability question. Who will be held accountable for a particular case-the individual IP dealing with the case or the firm she belongs to?

The other provision of IBC that deserves attention is that persons resident outside India can get licensed as IPs and can also form an IP agency. No other Indian law explicitly treats foreign professionals at par with Indian ones. The manner in which this provision is implemented will signal India's willingness to display its maturity as a global market.

This provision raises several questions pertaining to the regulation of the foreign nationals. In the United Kingdom for example, the insolvency profession is very well developed. Does an individual or a firm, who is already licensed as an insolvency practitioner in the UK, need to take the Indian IP exam again? Or is it just a specific portion of the exam focused on the Indian landscape that will be relevant for her? How will the IBBI regulate an IP, or for that matter an IP agency, who is already under the supervision of the UK insolvency regulator? Does the foreign IP need to become a member of an Indian IPA in addition to her membership of a recognised professional body in the UK? Can an IP agency registered in the UK open an office in India and regulate Indian IPs? How can a level playing field be created for foreign IPAs and Indian IPAs to compete with each other? Are there related laws that need to be amended or repealed to allow foreign IPs to practise and to be regulated in India?

The implementation of this provision requires careful balancing. On one side is the need for expertise and experience to implement the IBC and to give Indian debtors and creditors access to the best possible IP services available globally. This is especially important since India does not currently have a developed IP industry. On the other hand, the IBBI needs to ensure that foreign IPs and IPAs are properly regulated such that they can be held accountable for their conduct and for liabilities arising out of their work in India.

IPs are central to the success of IBC. Poor regulation of the IP industry will lead to poor bankruptcy outcomes. Through the enactment of these provisions, Parliament has taken unprecedented and bold but welcome steps towards creating a new paradigm of regulation in India. Now that IBC is about to be implemented, the IBBI and the IPAs need to issue clear and detailed regulations and by-laws addressing the questions arising from these provisions before the IP industry becomes operational.

The great Indian GDP measurement controversy

The great Indian GDP measurement controversy The Leap Blog, September 10, 2016.

Measuring the transmission of monetary policy in India

Measuring the transmission of monetary policy in India The Leap Blog, September 1, 2016.

Why inflation targeting works

Mint, August 16, 2016

The Reserve Bank of India (RBI) officially adopted inflation targeting (IT) as a monetary policy strategy in February 2015. A few days ago, the government notified a consumer inflation target of 4% to be followed till March 2021. Some economists have expressed fresh concerns about the wisdom of adopting IT. These concerns are misplaced. Inflation hurts everyone in the country from households to firms. Even moderately high inflation is bad for growth as is inflation volatility. The primary objective of monetary policy should be to ensure low and stable inflation. IT offers a framework to achieve this objective in a credible and sustainable manner. The adoption of IT by the RBI is a significant step in the right direction. The RBI should stick to this framework and put in place the operating procedure needed to implement IT.

Central banks have the power to print “fiat” money. Unlike money backed by metals such as silver or gold in the pre-World War II era, fiat money gets its value from a legal decree. Every fiat money needs a nominal anchor to tie down the price level. A nominal anchor can take various forms such as money supply, nominal gross domestic product (GDP), value of domestic currency relative to a foreign currency or a price measure such as the consumer price index (CPI). Since the collapse of the gold standard, central banks have tried all kinds of nominal anchors but with limited success. The world has increasingly moved towards inflation targeting where the nominal anchor is the CPI.

IT requires a central bank to adjust its monetary policy instruments in response to the gap between the forecast inflation rate and a pre-announced target rate. Most countries today follow a “flexible IT” framework. This gives the central bank discretion to respond to shocks such as a growth slowdown in the short run and meet the inflation target in the medium run. This is the kind of IT framework that has been adopted by the RBI. The objective is to pin down the value of the rupee to the price of the CPI basket.

IT anchors the inflation expectations of the private sector. It imposes discipline on monetary policy. Before the adoption of IT, monetary policy in India was conducted in an ad hoc manner. The RBI would target multiple indicators ranging from inflation and growth to exchange rate and trade balance. There was no clarity about the primary objective of monetary policy. The lack of accountability, clarity and transparency in monetary policy introduced uncertainty. Uncertainty about the central bank’s monetary policy objective is a risk factor for the economy.

In the absence of a specific mandate to target inflation, monetary policy in India was often used to achieve objectives unrelated to price stability. For example, during 2004-07, in response to a surge in foreign capital inflows, the RBI lowered the nominal interest rate. This was done to prevent the rupee from appreciating. This meant interest rates were kept low at a time when the economy was growing at a very high rate fuelled by a credit boom. A pro-cyclical monetary policy triggered inflationary pressures. CPI inflation began exceeding 5% from February 2006 onward. Post 2008, in response to double-digit inflation, the RBI pursued successive rounds of monetary tightening at a time when growth had begun slowing down. IT acts as a guard against this kind of a discretionary monetary policy.

IT was first adopted by the Reserve Bank of New Zealand in 1989. Since then, the number of countries using IT as a framework to conduct their monetary policy has steadily gone up. As of now, 36 countries, including India, have officially adopted IT (see table). In addition, all 19 countries in the euro zone are bound by the inflation target chosen by the European Central Bank. This takes the total count of IT countries to 55.

Inflation targeting countries

Year of adoption	Country	Target measure
1989	New Zealand	H CPI
1991	Canada	H CPI
1992	United Kingdom	H CPI
1993	Australia	H CPI
1995	Sweden	H CPI
1996	Mauritius	H CPI
1997	Israel, Czech Republic	H CPI
1998	Poland, South Korea	H CPI
1999	Brazil, Chile, Colombia	H CPI
2000	South Africa, Thailand	H CPI
2001	Mexico, Hungary, Iceland, Norway	H CPI
2002	Peru, Philippines	H CPI
2005	Guatemala, Indonesia, Romania	H CPI
2006	Armenia, Turkey	H CPI
2007	Ghana	H CPI
2008	Botswana	H CPI
2009	Serbia, Albania, Georgia	H CPI
2010	Moldova	H CPI
2011	Uganda	Core inflation
2012	USA	PCE**
2013	Japan	H CPI
2015	India	H CPI
*H CPI: Headline consumer price index. **PCE: Personal consumption expenditure. Source: Gill Hammond, 2011, State of the art of inflation targeting-2012, Centre for Central Banking Studies, Bank of England, and respective central bank websites.

Since the 2008 financial crisis, questions have been raised about the effectiveness of monetary policy to boost demand in developed countries where interest rates are close to zero. Yet, IT has stood the test of time through shocks, including the 2008 crisis. No country has moved away from IT as a framework and newer countries have adopted it after the crisis. What has changed is not the overarching framework of IT but the instruments used to meet the inflation target. Under conventional IT, short-term interest rates are the instruments of monetary policy. In the post-crisis period, several developed countries started using unconventional measures such as quantitative easing to achieve the inflation target. IT has continued to be the framework used to anchor inflation expectations. A broad consensus supported by empirical evidence has emerged that IT is effective in delivering low and stable inflation and anchoring inflation expectations in developed and emerging countries.

The RBI has taken the first step towards stabilizing inflation by formally adopting IT as India’s monetary policy framework. A lot more remains to be done in order for RBI to actually become an inflation-targeting central bank. Equipped with the IT mandate, the RBI needs to focus its efforts on strengthening monetary policy transmission (MPT) and putting in place a comprehensive operating procedure. Unless financial market reforms are undertaken to strengthen MPT, small rate changes will not have any effect on aggregate demand and hence inflation. The RBI should consider bigger changes in the interest rate. Small rate changes of 25 or 50 basis points work well in IT countries that have strong MPT. One basis point is one-hundredth of a percentage point.

The RBI needs to build internal technical capacity to forecast inflation using sophisticated econometric models, improve the quality of publicly available macroeconomic data, publish its forecasts of inflation and related macroeconomic indicators at regular intervals, systematically track the private sector’s inflation expectations, form the monetary policy committee (MPC) that will decide the interest rate, and furnish the MPC with necessary information, including data, and models used to forecast inflation.

IT is a whole new regime in monetary policymaking in India. The policy focus should now be on understanding how the new regime works and how this framework can be used to deliver low and stable inflation on a sustainable basis.

RBI should not regulate asset reconstruction companies

Business Standard, July 2, 2016 (with Pratik Datta)

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (also known as the Sarfaesi Act) facilitated the creation and regulation of Asset Reconstruction Companies or ARCs which purchase and manage stressed assets. A bill to amend the Sarfaesi Act is currently being reviewed by a Joint Parliamentary Committee (JPC). The amendment proposes to increase the powers of the Reserve Bank of India to regulate ARCs. This is problematic for two reasons. First, recovery of stressed assets by ARCs has failed. The new Insolvency and Bankruptcy Code 2016, or IBC, seeks to correct this. Regulation of ARCs outside the new bankruptcy law is unnecessary. Second, banking and stressed asset management are two separate businesses. The banking regulator has a conflict of interest in regulating the stressed asset management industry and should not be given this responsibility. The JPC in its review should consider these aspects of the proposed amendment.

So far, ARCs in India have failed in their primary purpose. While gross NPAs have risen to 10 per cent of total advances made by banks, the total value of loans sold to ARCs in the last two years is less than two per cent of the banking system. One reason for this is poor recovery due to an ineffective corporate insolvency resolution framework. The IBC is set to correct this situation and improve the recovery rate. Additionally, foreign investors have recently been allowed to invest in ARCs under the 100 per cent automatic route. This sequence of positive developments is likely to get derailed by the amendment. ARCs do not take deposits. They do not deal with retail consumers. Retail consumers cannot even invest in security receipts issued by ARCs, since they are not listed. There is no consumer protection concern. ARCs are too small to generate systemic risk for the financial system. Micro-prudential risk is also minimal. There is no market failure in the ARC industry that justifies heavy state intervention. From 2002 onward this industry has been repressed due to over-regulation. The proposed amendment makes it worse. The amendment gives unfettered powers to the RBI to remove the chairperson or any director from the board of ARCs on vague grounds like 'public interest', and to issue directions on the fees charged by ARCs and other expenses incurred by them. While the government liberalised foreign direct investment or FDI norms to invite foreign investors to invest in ARCs, the amendment gives arbitrary discretion to the RBI to remove ARC board members without basic natural justice. India has undergone a significant reform in the insolvency resolution space in the form of the IBC. Existing laws need to be in sync with the principle enshrined in the IBC to create a coherent framework for debt recovery and resolution. The IBC accords rights to every key stakeholder in the process without creating a bias among participants. The amendment goes against this principle by giving a special status to ARCs. The usage of the term ARC in India is misleading. Emerging economies like Indonesia, Malaysia and Korea set up government-funded vehicles as a one-off solution to a banking crisis situation, such as after the East Asian crisis of 1997. They are not regulated by the respective banking regulators of these countries. On the other hand, the United States and UK have hedge funds (distressed debt funds) that use private money to buy bad loans from banks. These funds are not regulated by the banking regulators either. In India, the Sarfaesi Act has created a unique situation where the so-called ARCs are non-government vehicles funded by corporate money; they are regulated by the banking regulator and are not a one-off creation. This regulatory architecture is fundamentally flawed. When an ARC buys a loan from a bank, it acquires the right to an assured cash-flow from the borrower. If the borrower defaults, the ARC can recover the due amount from the borrower. The business of stressed asset recovery is disconnected from the business of banking. There is no reason why the banking regulator should regulate the ARC industry in India, when globally it does not. The banking regulator has conflicting interests in regulating ARCs. If the regulator fails in micro-prudential regulation of banks, non-performing assets or NPAs will build up. If these NPAs are sold to independent ARCs at marked to market, the actual magnitude of prudential mismanagement of banks will be evident - a clear sign of the banking regulator's failure. Instead, if the banking regulator could "direct" the ARCs to absorb the NPAs at a higher price than what they are actually worth, the scale of the failure may not be fully evident. Thus, the banking regulator has perverse incentives in regulating ARCs. Further, the amendment is unconstitutional in spirit. It proposes that penalty orders against ARCs by the RBI can be appealed before an Appellate Authority comprising only RBI officers. Effectively, the RBI will be the judge of its own cause! This violates the principle of independence of the judiciary, which is equally applicable in the regulatory context. Regulators are "mini states" and their quasi-judicial functions (including the appellate function) must be insulated from their executive role. In the financial sector, an independent tribunal - the Securities Appellate Tribunal or SAT - hears appeals against orders by Sebi, Irdai and PFRDA. The Justice B N Srikrishna-led Financial Sector Legislative Reforms Commission had recommended that the RBI's orders should also be appealed to SAT. In this backdrop, creation of a parallel mechanism within the RBI to hear appeals against its own orders is a retrograde step and is potentially unconstitutional. The amendment will stifle the development of the struggling ARC industry and hamper the reform process initiated by the IBC and the liberalised FDI norms. The JPC must rectify this, given the unfolding NPA crisis. ARCs should be regulated by Sebi-like private equity funds investing in stressed assets and not by the RBI. This industry needs room to grow, which only light-touch regulation can provide.

Inflation targeting: A long way to go

Mint, June 29, 2016

The Finance Bill, 2016, amended the Reserve Bank of India (RBI) Act, 1934, to define inflation targeting (IT) as the central bank’s primary objective. Passing a law by itself is not sufficient to achieve the objective. Reforms will be needed on two fronts to build institutional capabilities that will add up to a working IT system. These involve (i) changes in the working of the central bank, including, releasing better and more frequent macroeconomic data, analysis and inflation forecasts in a timely manner; constituting the monetary policy committee and putting in place an operating procedure; letting the currency float and liberalizing the capital account; (ii) changes in monetary policy transmission, through financial market reforms.

A central feature of a well-functioning monetary policy is monetary policy transmission (MPT). MPT in India is ineffective. In an ideal world, changes in RBI’s policy repo rate—the rate at which it lends to banks—would affect the entire economy through three channels of transmission. First, banks would change the rates they charge their customers. Second, the bond market would be commensurately affected at all maturities. Third, the exchange rate would change because of the impact of the interest rate change on debt inflows and outflows.

None of these channels works in India. First, India is a bank-dominated economy but the number of banks have not increased noticeably over time. In a decade or so, only two new commercial bank licences were granted in 2015. The landscape is dominated by public sector banks which account for 80% of the deposits but lack competitive energy. Private and foreign banks face a plethora of entry barriers. While RBI has granted licences to payments and small finance banks, these will not move the needle in an otherwise stagnant banking environment.

The relatively smaller number of banks in the economy thwarts competition among the existing banks, who do not feel the necessity to pass on the rate changes to the final consumers. This renders the bank lending channel of transmission ineffective.

Secondly, bond market development has been an important failure of financial sector reforms. In advanced countries such as the US, the bond market is an important transmission channel through which changes in monetary policy affect the yield curve. In India, we do not observe this channel. In the absence of a large and liquid bond market, the burden of MPT falls squarely on the banks. For the bond market to develop, reforms are needed to facilitate the bond-currency-derivatives nexus.

Third, in an open economy with flexible exchange rate and monetary independence, when the central bank changes the policy rate, capital flows in or out of the economy, depending on the direction of the policy rate change. This leads to movements in the economy’s exchange rate. This is the third channel of transmission through which sectors linked to currency movements such as tradables feel the impact of a monetary policy change.

In India, there exist several restrictions on the movement of capital flows. Compared to other emerging economies, India still enjoys a limited degree of integration with international financial markets. So, any change in RBI’s policy rate does not necessarily result in concomitant changes in capital flows. Also, in India, any movement in the currency is actively managed by RBI through market interventions. These reduce the effectiveness of the exchange rate channel of transmission as corroborated by evidence found in our recent paper (Monetary Transmission in Developing Countries: Evidence from India by Prachi Mishra, Peter Montiel and Rajeswari Sengupta). In the absence of an open capital account and flexible exchange rate, the third channel of MPT is rendered ineffective.

In an ideal world, through these MPT channels, the effect of a rate change would be passed on to a large share of the population connected to the formal financial system. In other words, for MPT to be effective, financial inclusion is also important. In India, when RBI changes the policy rate, the impact is felt by a small fraction of the population which has access to the formal financial sector. Only 52% of those aged 15 years and above have accounts at a financial institution in India as of 2014. This is low when compared to 98% in Australia, 78% in China, 96% in Singapore, 98% in the UK and 93% in the US. As a result, a small share of Indian population bears a disproportionate burden of the impact of a monetary policy change.

In the absence of a powerful MPT, the only way a monetary policy change can affect the economy is if it is large in magnitude. For example, when C. Rangarajan was RBI governor from 1992 to 1997, he pursued aggressive monetary contraction in the mid-1990s amidst an inflation crisis. In response, consumer price index inflation went down from 10% to 4% in two years. In those days, because MPT was weak, a large change in monetary policy was needed to combat inflation. Little has changed since then.

Thus, there are three paths that can be followed in the context of MPT: (i) Adopt structural reforms to de-clog the channels of transmission. This entails improving financial inclusion, fostering a competitive environment for banks, improving the functioning of the bond market, liberalizing the capital account and letting the currency float; (ii) Administer big changes in the policy rate; (iii) Do nothing on the first and deliver only small changes in the policy rate. This is least painful and perhaps easiest to implement in the short run, but does not create any real impact on the economy.

The government has done its bit by amending the RBI Act to incorporate IT as an objective. RBI now needs to undertake a series of actions in order to actually become an inflation-targeting central bank.