Has Jaitley Managed to Fully Shut the Door on India's Macroeconomic Problems?

Over the past week, finance minister Arun Jaitley had a lot of attention focussed on him – something that has not happened in some time.

First, he announced a slew of measures aimed at arresting the rupee’s steady slide. (Though the government had been unwavering in its claim that the fall in the rupee’s value did not bother it – at times, indeed, very nearly suggesting  that the fall was even desirable – the unease was palpable, more so because rising crude prices made it a double whammy.)

And then there was the announcement of a ‘mega- merger’ in the banking space – one of the big bang ‘reforms’ that every government in recent years has so yearned for. The finance minister variously described the potential banking amalgam (to be created out of the merger of Vijaya Bank and Dena Bank with Bank of Baroda) as ‘the second biggest public sector bank’, ‘the third largest lender’ and ‘a truly mega bank’.

Though the immediate objectives of these two sets of initiatives are not similar, both were expected to ramp up market sentiment in the gathering gloom of domestic and global uncertainties while simultaneously ‘talking up’ the rupee somewhat.

While it is early days yet for the results of these high-octane announcements to show clearly, the first signs have been far from promising. The stock markets have been dipping sharply these last few days, with September 18 alone witnessing a 295-point fall in the BSE Sensex, the corresponding drop in the NSE Nifty being of 99 points. Public sector bank stocks received a drubbing. And, refusing to heed the finance minister's remonstrance, the rupee ended a miserable day’s run nudging the 73 mark (so close to the eligibility criteria for a seat on the Margdarshak High Table, as Arun Shourie memorably reminded us all the other day).

A more unambiguous thumbs-down is not easy to visualise.

But the market, as we all know, can be as irrational in its euphoric surges as in its precipitous declines. So, do we really need to read too much into these grim tidings? Maybe a more relevant question would be: should the market have reacted differently? Is the market missing out on the big picture, or is the big picture really very different from what the finance minister would have us believe? We can break the puzzle down easily enough: by simply listing out the changes proposed and making a commonsense deduction of their implications.

The measures targeting the rupee’s value are broadly the following five:

1. Relaxations  in the borrowing norms for Indian corporates raising External Commercial Borrowings (ECBs) for funding their manufacturing operations;
2. Relaxations in investment limits for Foreign Portfolio Investors in India’s corporate debt market;
3. Changes in the structure of the so-called ‘masala bond’ market ( relating to rupee-denominated corporate bonds raised by Indian companies in overseas debt markets);
4. Exemption of these ‘masala bonds’ from the incidence of withholding tax, presently for the financial year 2018-19; and
5. Restrictions, not yet specified, on imports of ‘non-essential’ items.

Clearly, the common thread running through these proposals is the desire to ease the pressures on the country’s corpus of foreign currency funds by (a) facilitating the sourcing of such funds from overseas markets and (b) encouraging the inflow of foreign currency funds into the Indian market more aggressively. Intended import curbs are, of course, a more straightforward method of scaling down the demand for foreign currency.

So far, so good. But isn’t an obvious question being missed here? In a scenario of a steadily depreciating rupee, how do we induce foreign investors to bring in more cash into India? How do we incentivise such cash flows, except perhaps by significantly raising domestic interest rates, a step that brings in its trail its own set of monetary policy problems, eventually affecting both consumption and productive investment cycles negatively? Do not such relaxations really work when the domestic currency is actually strengthening, rather than shedding value rapidly, as the rupee is doing now (Already this year, it has lost about 14%). As for the ‘masala bond’ market, it is as yet so small as to have little impact in the short-term, even if it were to be tweaked more substantively than by a temporary relief in withholding tax or adding to the existing ‘market-makers’.

While these proposed measures could, at best, elicit only a lukewarm response immediately – and that is exactly what has happened – there are a couple of serious issues implicit in the relaxations in the ECB norms. As of now, Indian manufacturing companies can raise ECBs with a minimum maturity of at least three years.

The changes Jaitley proposes, however, will set the maturity threshold at a vastly reduced one year for borrowings up to USD 50 million  (roughly equivalent to Rs 4 billion today). What this means is that the repayment liability may arise that much sooner, too. One-year funds being typically cheaper than three-year borrowings – as also being somewhat easier to procure – most companies are likely to plump for shorter-maturity ECBs, with the possibility of their running up an additional liquidity risk and also potentially an interest rate risk, because a renegotiated ECB after one year is likely to attract a higher interest rate if the markets have moved north in the meanwhile. With the US Fed remaining wary of inflationary pressures, further rate hikes are not only possible but even probable. It is a safe guess that the RBI would not have taken kindly to this change in the ECB norms. In the end, though, the central bank may have found itself overruled by the government.

As of now, Indian manufacturing companies can raise ECBs with a minimum maturity of at least three years. Credit: Reuters/Shailesh Andrade/File Photo.

The fine print in the proposed ECB guidelines contains another, potentially far riskier provision. Most ECBs are subject to a mandatory hedging requirement, which means that the ECB borrower is required to necessarily cover the loan principal as well as the coupon (or periodic interest payments) through financial hedges such as the ‘forward cover’ which enables the borrower to crystallise its exact future liability under the foreign currency-denominated borrowing (the ECB) in rupee terms, thus mitigating the currency fluctuation risk. In other words, the ‘hedging’ mechanism neutralises the negative impact of the (possible) falling value of the Rupee on the borrower’s profits and cash flows. Existing RBI guidelines stipulate a minimum tenor of one year for the hedge and require the borrower to toll over, or extend, the hedge through the life of the ECB so that the exposure is never left uncovered by this risk-mitigating instrument.

For some unexplained reasons, Jaitley chose to free the infrastructural sector (power, roads, ports, telecom etc) from this hedging requirement in respect of its ECBs. This is particularly baffling because the infrastructure sector has had more than its fair share of risks at the best of times. Long gestation periods, operational uncertainties and unstable cash flows have combined to make the banking sector’s loans to infrastructure a near nightmare in general. Indeed, the lion’s share of the public sector banks’ stressed loans are owed by projects from this sector. With this in the background, it seems extraordinary that the finance minister opened the door to another significant additional risk here. The fact that infrastructure projects typically borrow long-term only amplifies this risk many times over. Surprisingly little discussion has taken place around this change yet, but this relaxation carries the potential of a disaster.

As for the ‘mega merger’, several analysts have  bared its downside already. A big bank is not necessarily a strong bank at most times. On the contrary, relatively smaller outfits often score over their big brothers both in operational efficiency and customer loyalty. The brand equity of a mid-sized bank is more often greater than a behemoth when it comes especially to retail banking. Then, when you lump three very different entities – with completely dissimilar balance sheet structures, work environments, customer orientations and technology adaptation levels, not to speak of workforce profiles – you are frankly asking for trouble. Rather than turning out to be the ‘win-win’ situation for everyone concerned that the FM was making it out to be, this amalgamation may in fact prove to be a losing proposition for all stakeholders. Its only achievement – and that also only a short-term one, at best – could be freeing the government of its liability to capitalise the weaker bank for now. But should the government’s (perceived) convenience hold the banks’ future to ransom? At a time when the public sector banking system is facing what many consider an existential crisis, surely these banks could have been spared additional churning and pain for now?

Jaitley was heard saying that the merger of the banks of the State Bank Group, completed in 2017, has been a spectacular success. Sadly, the FM is either ill-informed or unwilling to acknowledge the truth. Here was a case of a bunch of banks having many similarities, even synergies, between themselves and the long-established practice of the intra-group mobility of officers had helped bridge the work culture gaps between the Group banks in considerable degree. And yet, the customer and staff profiles stayed different, and both staff and customer loyalties made the transitions quite choppy. (This, despite the fact that the process of merger was actually spread over 9 years, from 2008 to 2017.)

The transition itself saw all significant business initiatives, even loan recoveries, being deprioritised for its duration. Besides, officers from the smaller banks joined the parent with definite –in some cases, crippling – handicaps in terms of the eligibility criteria for career progression.  What this does for the organisation’s HR climate is not difficult to understand. It will in fact be years before the rough edges of the merger process are sufficiently smoothened to make the merged entity look the way the finance minister would like us to see it. Meanwhile, the losses in client patronage, employee loyalty/motivation and operational efficiency would remain undocumented but real. The fact that the last lap of the merger process – completed in April, 2017 – was pushed relentlessly by the government made things that much more difficult, but any inorganic growth that happens through diktat rather than through business logic is unlikely to bear fruit soon. It is quite unsettling that already it is being said that the ‘mega merger’ proposed now will happen in six to nine months, as though that is more than enough time!

And what speaks volumes of the ‘well-considered’ nature of the decision is the frank surprise with which two of the three banks involved reacted to the news. Another eminently avoidable move is to entrust a CEO nearing his/her superannuation with such a merger/amalgamation initiative. It may be a coincidence, but both in the case of State Bank of India and now that of Bank of Baroda, a CEO nearing the end of her/his term is being given the job that only someone with a real stake in the bank’s future should in fairness have been asked to handle.

An interesting coincidence: just days back, the former governor of the RBI had mentioned in his submission to the Parliamentary Estimates Committee on Bank NPAs a few possible government actions that had best be avoided. The first item he happened to mention was a ‘Bad Bank’ (meaning a bank set up for the sole purpose of managing NPAs) while the very next was ‘mergers’. It does not call for an extraordinary feat of imagination to visualise the wry smiles that the new announcement would have drawn out on the faces of some members of that committee.

Based out of Bangalore, Anjan Basu commentates on a range of subjects. He can be reached at basuanjan52@gmail.com

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