Interesting readings

Bruce
Riedel has a great story in the National Interest about
the 1962 India-China war and its aftermath.

Nitin
Pai in the Business Standard on how to better manage
immigration into India.

The
adventures faced in running household surveys in India.

I have written earlier about the new world of intense competition
for the top two Indian financial
products: Nifty
and rupee. A
big step
up in
competition against the NSE Nifty options has begun, against a
serious and heavyweight rival.

Palak
Shah, in the Business Standard, describes some
interesting developments at the Delhi Stock Exchange. DSE has
fumbled before on finding the right partners; perhaps this will
set the stage for building DSE into a serious player in the Indian
exchange industry. And,
see Jeff
Glekin on Reuters Breakingviews on India's 3rd stock
exchange.

How
should liberal democracies deal with China and Russia? by
Michael Ignatieff.

Bo
Xilai: power, death and politics by Jamil Anderlini in
the Financial Times.

If you've wondered why Microsoft faded away in the recent decade,
read Microsoft's
lost decade by Kurt Eichenwald in Vanity Fair. On
this subject,
read David
Stutz who wrote an open letter when he left Microsoft in 2003. I
looked back into
1997
and thought that while parts did not work out, it was a pretty good
call: two years before the MS stock price peaked and roughly four
years before the cognoscenti understood that Microsoft was a utility
in decline.

Robert
Shiller interprets China's Great Leap Forward as a speculative
bubble.

China's
economy: Apocalypse soon? by Mark McDonald in the IHT.

Jayanth
Varma on various notions of price. Also see one of my old
columns, When
marking to market fails.

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Egregious Indian protectionism against trade in services

For many decades, India was one of the most protectionist countries in the world. This did great damage to growth and knowledge in India. Tariffs dropped from ridiculous levels to ridiculous levels in the early 1990s and then got stuck there. Yashwant Sinha, as Finance Minister, initiated a remarkable program of cutting the peak rate by five percentage points every year. This worked very well: It steadily got rates down and also gave a roadmap to the domestic industry about what would happen next.



In January 2004, Jaswant Singh as Finance Minister announced further cuts to customs duties even though it was not part of the budget. This was criticised in the press as being a `populist' move. I thought it was a big day in India's history: when a Finance Minister feels that trade liberalisation is so important that it cannot wait  for February 2005 (since Feb 2004 was to be a vote on account), and when he gets criticised on the grounds that this is populist.



While there is more ground to cover on removing barriers to trade in goods (e.g. barriers to trade in agricultural products), by and large, India is doing well on this. The old instinctive protectionism has subsided. Two big areas for work remain. First, all customs duty rates are not yet at zero. And, we have one big gap: the lack of a proper GST, through which we would get to residence-based taxation. The GST on imports would be charged on imports, giving parity between a factory just inside the border and one just outside. And, the zero-rating of exports would mean that the GST burden suffered by a non-resident is refunded to him. The fundamental law of tax policy in this age of globalisation is: You do not tax non-residents.



Does this mean that we're in good shape on trade liberalisation? No. The big gaping problem is trade in services. Most of world GDP and India's GDP today is services. Even if we do full free trade on agricultural and non-agricultural goods, that only covers 40% of GDP. The real story of international trade is now in trade in services.



With trade in services, old-style Indian protectionism reigns. For the first time now, we have some hard data on this. The World Bank has released a `Services Trade Restrictions Database' which measures protectionism in services across the world. To get the story about what was done, read the voxEU column by Aaditya Mattoo, Ingo Borchert and Batshur Gootliz. Here's the key picture:

The graph puts per capita GDP (in log scale) on the x axis and the measure of barriers to services trade on the y axis. Values of 0 imply perfectly open and values of 100 imply perfectly closed. The regression line shows us that by and large, when countries get richer, they reduce restrictions. The score goes down from roughly 40 (on average) for the poorest countries to roughly 20 (on average) for the richest ones.



India sticks out as an outlier, with a score of above 65.7. We are more restrictive than Iran. Only Ethiopia is more restrictive than India, among all the countries of the whole world. Here is some more detail about what is going wrong:

This shows us the variation of India's restrictions by sub-sectors and by modes. While there is some variation, it is all appallingly bad. If we only got to the conditional mean for the Indian level of per capita GDP, we'd have to get the score from 67.5 to roughly 37.5, which is a big decline. And there is no reason to stop there; we need to eliminate protectionism far beyond what's seen in the conditional mean.



To be open to trade in today's world is to be open to trade in services, given the preponderant share of services in GDP. What we are doing is profoundly wrong. We always had an instinctive sense that India does worse on trade in services when compared with trade in goods. The World Bank has made a great contribution by building a comparable database across countries, to give us a concrete sense of where we are and how bad things are.



If we want to harness gains from trade in goods, we have to open up to trade in services also. Finance, transportation, and other services are the vital glue that makes trade in goods possible. Our mistakes on services trade liberalisation are holding back our gains from trade in goods also.



You may like to also see older blog posts: Globalisation: the glass is half empty, 28 January 2011, and Getting to a liberal trade regime, 15 December 2009.

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The disaster at Maruti

The news from Maruti is disgusting. I have been curiously watching how the stock market takes it in:

That Maruti has serious labour problems has been known for a long time. But the brutality that unfolded in recent days was out of the world. It was news. When I read about it on Thursday, it seemed to me that Maruti was facing a Tata Motors style situation: of suffering the fixed cost of closing down the existing plant and relocating to a state with better governance. The costs faced in this would be substantial. In that case, a 6 per cent decline of the stock price seemed pretty modest. I watched the small recovery on Friday with surprise. Surely, the cost and complexity of moving out of Manesar is worse than 5%.



Today, on Monday, the market has shifted from a less sanguine assessment to a 10% drop in the stock price. I wonder if this is new information or a modified judgment about how this will play out. Were the speculators on late Friday evening just wrong, or did some new information break?

Bad macroeconomic outcomes and social stress

I would conjecture that poor macroeconomic performance -- low GDP growth and high inflation -- is correlated with greater stress of this nature. With inflation, the logic is straightforward: The worker who had a nominal wage contract finds the need to renegotiate when the value of the rupee changes. This links back to the earlier discussion here on why solving India's inflation crisis is important. Too often, we in India are cavalier about inflation. But we should see inflation as an acid that corrodes all nominal contracts, whether stated or unstated. Renegotiation is costly.



Turning to GDP growth, most people that I know seem to think that a couple of per cent of real per capita GDP growth is important for keeping the peace. A lot of people become a lot more unhappy when growth slows. Indian democracy does a pretty good job of containing the angst. There will be no revolution here. But life is substantially easier if the engine of GDP growth is purring. When it stalls -- as it appears to have done in 2012 -- a whole host of social problems erupt.

Law and order as the fundamental foundation of civilisation

This is a reminder to us about how law and order is the fundamental precondition of civilisation. The most important public good of all, the first claim on the resources of the State including the time and attention of the senior leadership, is police, courts and laws. The entire story of the market economy and high GDP growth can only come about when safety of life and property is guaranteed. The events in Maruti are an important reminder to every investor about the weaknesses of governance in Haryana.



In tracking conditions in any state, I find it useful to watch the time-series of the share of the state in the overall all-India investments outstanding, that are `under implementation', in the CMIE Capex database. Here's an example, for Bihar:







November 2005 is the date that Nitish Kumar became the new CM of Bihar. He is widely reputed to have made important progress on improving law and order. At first, the share of Bihar (in all-India under implementation investment) continued to drop. I am sure the changes brought about by Nitish took time; Rome wasn't built in a day. And, after improvements come about, skeptical investors would take some time in making up their minds that conditions are now better. From 2009 onwards, it appears that there is some upward movement. The overall gain seems to be roughly 1 per cent of the all-India total, which is a significant change.



Compare this with Haryana:

There was a big spurt in the share of Haryana in the overall under-implementation investment in India. After that, the numbers have steadily trended down. Is Haryana suffering from a resource curse in terms of proximity to Delhi?

Rethinking labour law

In the early decades about independence, India constructed a remarkable legal framework which was strongly pro-trade-union. Few countries have enshrined trade unions into laws on the scale that India has done. In those years, trade unions were primarily led by socialist/communist parties. While we may disagree with their views, there was a fundamental decency about them. Some of the best human beings in India, in the 1950s and 1960s, were communist. Perhaps this coloured our thinking, and encouraged us to respect and empower trade unions strongly in the legal framework which fell into place over the 1960s and the dark days of the 1970s.



Today, a hyper-empowered trade union is a potent tool for extortion in the hands of local goons. To solve this problem, it is important to rethink the checks and balances embedded in labour law, which have gone too far in the direction of making trade unions strong. Now that we know that the people in trade unions are most likely local goons, do we want to hyper-empower them through labour law?

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The two escape routes away from domestic formal-sector finance

Three problems afflict formal-sector finance in India today: capital controls, taxation, and financial policy. The most important financial products traded in the formal sector in India -- the stock market index (Nifty) and the exchange rate (the rupee) -- are under enormous pressure as a consequence.



One dimension, that has been emphasised in the existing discussions, is the flight to offshore markets. There is another: the trade goes off into underground markets. These come in two kinds. In the field of commodity futures, it appears that important price discovery and liquidity is found on unregulated markets. As an example, in Gujarat, the town of Bhabhar is famous for having a huge oilseeds and edible oil futures market. Babhar is a true market: it has liquidity and discovers the price.



A second mechanism is a class of market mechanisms which leech off the price discovery of a main market, do not really offer liquidity of their own, and let people achieve trades. In Indian parlance, these are called the `dabba market'. Here is how it works:

1. The main market where Nifty trades is NSE. But if a customer goes there, he has to suffer the full burden of the securities transaction tax, the charge by the NSE member firm, etc.


2. The dabba operator (`DO') sets himself up in business offering trading services in Nifty futures.


3. Many individuals place buy/sell trades with him. These are meticulously tracked; their profits and losses are calculated and money is exchanged w.r.t. each customer.


4. Through this, the DO is effectively accepting orders -- like an exchange -- and doing daily mark-to-market w.r.t. the customers.


5. On average, the sum total of trades by many customers adds up to zero. So the net exposure of the DO is roughly 0. If an exposure builds up, he might choose to lay off his risk on NSE.


6. The DO charges much less than the NSE member since he does not pay STT and his establishment costs are lower.


7. He is a big man in the community. He can break your bones. So you will not default on him. So he charges less margin. This is another attraction - but it means that some fraction of customers endup entangling with the underworld.


8. The DO will work with black money (i.e. cash). This is another attraction, compared with the all-cheques-and-PAN-numbers world of NSE. The short-term capital gains tax (or worse, ordinary business income treatment of winnings) is then avoided.

Bhavesh Shah, reporting from Ahmedabad in DNA, tells us that dabba trading has gotten bigger of late. He also points out that the DOs have been doing some system-building to make their business more efficient. Dabba trading is one response of economic agents to the problems of taxation and improper financial policy. It also happens to a varying degree with trading in India of international underlyings (e.g. crude oil or gold), where capital controls prevent locals from accessing the world market.

In summary, when India makes mistakes on three things -- capital controls, taxation and financial policy -- there are two kinds of responses on the part of onshore and offshore users of India-related financial markets. On one hand, users go off to overseas venues. On the other hand, users shift towards informality. In the limit, large scale mistakes on the three fronts will drive the bulk of customers away from the formal sector onshore market venues. RBI, the tax authorities and SEBI will then lord over an insignificant part of the market.

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Attitudes and beliefs in India

We generally know remarkably little about what the people of India feel and think. Politicians have an interest in emphasising ideological biases. Systematic surveys about attitudes and beliefs are generally not taking place. Under these conditions, I find it useful to take whatever scraps of evidence one can get from efforts rooted outside India which are measuring attitudes and beliefs in India.



One important institution working on these things is the Pew Research Center which runs the `Pew Global Attitudes Project'. They regularly runs surveys in India, and I have blogged about some of these results before.



Some interesting new results were released yesterday. The focus of the study is on gloom in the world economy. With apologies to the authors, I'm going to ignore many elements of that effort, for I found some sub-components which interested me more. Their survey methods seem to be quite good; a sample of 4018 adults spread over a large swathe of India.

Are you better off than you were five years ago?

The basic engine of high growth is delivering: a lot of people feel they are better off than conditions prevalent five years ago. There is a holdout of roughly a quarter of India which says they are worse off.

Can most succeed if they work hard?

Do we have a Calvinist ethos? In the overall average, 67 per cent of India believes that most succeed if they work hard. This is behind the US (which is at 77 per cent) and Pakistan (81 per cent) but ahead of all countries in Europe and also China (45 per cent) and Japan (40 per cent).



The rich are more in favour of this proposition. There are 8 countries where this belief varies strongly by income:

While the overall average is 67 per cent, among the rich we have a much higher number (74 per cent in support). This is next only to the US. This drops off to 64 per cent among the poor. It is interesting that the middle class is what feels the least good about hard work, with 62 per cent. We have a bit more of a Calvinist ethos at the two extremes of the income distribution.

Support for the market economy

Support for the market economy is strong. Four large countries are ahead of India on this score: Brazil, China, Germany, the US. The UK is the same as India on this. Is there support for the market economy in these six countries because the outlook for these countries for the next decade is good, or is it the other way around?

The rich are particularly upbeat when compared with the poor

On an array of questions, the Indian rich are much more optimistic then the poor.

Finally, who's to blame

Those who said that economic conditions were bad were asked an additional question: Who is to blame. The results are unsurprising, for us:

92 per cent of India knows who is at fault: The Indian State. There isn't much anti-finance in India nor is there much anti-US. In places like Brazil, 29 per cent blame finance and in places like Pakistan, 32 per cent blame the US.





Most of us generally expect that mainstream attitudes in India would be quite left-wing, pro-State, anti-market, etc. The evidence does not seem to support these preconceptions.

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Important step backwards for pension reforms in India

In the best of times, consumers do badly in personal financial decisions. Here is a stark example of what goes wrong. Mark Hulbert wrote in the New York Times, about research by Choi, Laibson and Madrian, 2010:

MANY index funds track the Standard & Poor's 500, but they differ from one another in one major respect: their fees. You'd think that it would be obvious to investors to pick the fund that charges the least. But you'd be wrong.

In fact, this truth was anything but obvious to a group of elite students. In an elaborate simulation created by several researchers, many students at Harvard and the Wharton School of the University of Pennsylvania failed to select the lowest-cost index fund for their portfolios, even when they were all but spoon-fed the right answer.

There is a problem of consumer protection here.  Financial policy cannot and must not be designed on the premise of caveat emptor, that the individuals making choices are the ones best equipped to look out for themselves. The great bulk of financial regulation is about making the world safer for the individuals making those choices.




These problems are present with insurance and mutual funds in India, where sales practices and product features have been a scandal for a long time, until C. B. Bhave's SEBI started trying to do something about it. These problems would be present to an even greater degree in a nationwide pension system, where participation has two features: (a) To some extent, it would be involuntary; many people would be pushed into pension system participation without self-selecting themselves as is the case with products such as mutual funds, and (b) Whether participants come into a nationwide pension system through voluntary choice or not, they are likely to be less sophisticated than the `elite students' described above, and thus face even more difficult problems of household financial choice.



The key insight of what I term the `second generation pension reforms' is that while we must do defined contribution (DC) pension system so as to keep pension planning away from the balance sheet of the State, we should use public policy decisions about design of the pension system in order to further the goals of consumer protection. One big insight in this is on pricing. Households are seldom able to understand the charges of fund managers. The `elite students' that do fine in comparing an iphone versus an Android phone on features and pricing tend to fumble when it comes to financial products.



The clean answer to this is: Standardise fund management into a group of index funds (one for equities, one for government bonds, etc) and procure fund managers through an auction. This has two consequences: economies of scale (a small number of very large AUMs) and low prices (since fund managers compete with each other in an auction). This idea is found in the original Project OASIS report which designed the New Pension System (NPS), it was successfully implemented by PFRDA when the NPS began, it has been used in other places such as the EPFO, the civil service pension of the US (which is named the Thrift Savings Plan (TSP)), etc. For the back story of the NPS, see link and link. To use Raju Chitale's phrase, we are using public procurement to overcome the market failures of the fund industry.



In this setting, I was disappointed to learn that PFRDA has just announced that they have given up on this key idea of the NPS:

19.1 The PF can fix the Investment Management Fee to be charged to the subscribers subject to a ceiling/cap, as may be prescribed by the Authority from time to time.

I disagree. This loses one of the essential features of the NPS. This makes the NPS closer to the fund management products run by mutual funds and insurance companies. To this extent, the value added of NPS is contaminated: why construct the NPS if households can do this same thing through mutual funds?



It is important to worry about the political economy of finance. The financial industry will generally tend to achieve dominant mind-share within regulatory agencies. The great unwashed masses, the greatest beneficiaries of sound economic policy, will never have a voice in the policy discourse. In India, our puzzle is that of avoiding both extremes: of socialist stagnation (to use Arvind Virmani's phrase) at one extreme, and crony capitalism at the other. PFRDA runs the risk of veering towards the latter.

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The glacial pace of change: QFI edition

In the Percy Mistry report, there are some striking examples of the inability of the Indian policy process to deliver change at a reasonable pace. See: Box 9.2, page 127 (index futures); Box 9.3, page 128 (CDO); Box 9.4, page 128 (Gold ETF), Box 9.5, page 129 (interest rate futures in the US). See a similar chronology for currency futures.



Here is another example:

• First government committe report which talks about QFI: Ministry of Finance Working Group on Financial Flows, chaired by U. K. Sinha, 30 August 2010. 


• First QFI signs up: this month, i.e. 22 months later.

What's disappointing about the Indian policy process is that many of us in India will think "a 22 month delay - not bad!".

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RBI vision document on payments: An evaluation

by Madhavi Pundit and Suyash Rai.



On June 27, RBI published its Payment System Vision Document (2012-15). The document shows RBI's vision and mission for the payment system, and specifies the objectives, approaches and courses of action emanating from the same. It is a laudable step taken by RBI to discuss its plans for payments in India. All regulatory activities, such as banking and capital account liberalisation should have vision documents to similarly show the road map. They bring clarity to market participants, and helps everyone plan better.



A vision document is an opportunity to think from first principles, and to dream about the payments landscape. The document does not do this sufficiently.



Going by the ideas of the vision document, it is difficult to hold RBI accountable to it or to evaluate its role as a regulator, because it is not clear what we should expect the payment system to achieve, say, five years from now. Though the vision itself may be a general, aspirational statement, it should be accompanied by quantifiable goals that can be achieved by Indian payments system (regulator + industry). For example, the regulator can set objectives that by 2015, cash will be x% of transactions, or that cheques will be phased out by 2020. RBI can then, as a regulator, take steps to facilitate the achievement of such goals, with the expectation that other participants will play their part. Such sharp statements are absent in the document.



Once a suitably ambitious, but quantifiable, vision for payments has been stated, achieving it requires looking beyond incremental modifications. This brings us to the kind of steps RBI has proposed in the document; the things that it will do to achieve the vision over the next three years. For a vision document, the proposed steps are rather tactical and operational. From this document, it seems RBI is running all payment systems, with incidental cooperation from the private sector. It is difficult to imagine how industry participants should work towards the vision. For an example of how this can be done, contrast the RBI document with the Strategic Review of Innovation in the Payments System, recently released by the Reserve Bank of Australia. Unlike RBI's document, the focus of this document is purely strategic, and on removing barriers that prevent market participants from innovating.



The document should clearly state what RBI sees as its role in payment systems - which is above all, that of a regulator - and what it sees as the role of market participants. While the document focuses on the development of certain types of electronic payment systems, certain standards, authorisation methods etc., there are a host of other ways the market could innovate. The document's approach precludes other means by which the same goal of higher electronic payments can be achieved.



All regulation must be rooted in market failures that damage the interests of consumers or threaten systemic crises. A specific regulation must address a specific market failure and thus tangibly further consumer protection or systemic stability:

1. In payment systems, consumer protection would entail measures that ensure transparency and disclosure by payment providers, so that consumers receive what they are promised.


2. In addition, providers must be subjected to micro-prudential regulations, such as capital requirements, risk management and investment restrictions that ensure their safety and soundness, based on the risks they take. The risk based approach means that small value systems with real-time payments need less regulation than large value systems that hold clients' funds for a certain amount of time.


3. For systemic stability, enhanced regulation and supervision of systemically important payment systems, especially back-end infrastructure, such as RTGS, is required.

RBI ought to focus on these regulatory objectives, where it would deliver public goods, rather than take on `private goods' functions that can be handled ably by the market. Systems such as NEFT and ECS, which essentially require capabilities that go beyond a regulator's core competence, can be run well by the private sector, under RBI's regulations. In such systems, competition is of essence.



From this perspective, the vision document starts looking less impressive. It is tied to the existing ways of doing things, and intent on incrementally improving them, rather than questioning the existing paradigm. This is unsatisfactory, for a paradigm shift is what India most requires.



Perhaps that is why there seems to be a lack of clarity of purpose. For example, RBI talks about investing in cheque systems and electronic systems at the same time. Developing a grid system to replace clearing houses as suggested is expensive. If the objective is to phase out cheques and promote electronic payments, the revamp of the cheque clearing system has no place in the vision document for electronic payments.



The emphasis on electronic payments is welcome. It is time for India to become a less-cash society, and ultimately a cash-less society. Myriad inexpensive, safe and useful electronic technologies are available, and more are being developed as we write. Hence the extensive use of cash and other paper-based instruments is not acceptable. They are expensive and inconvenient, and cost the most to those with the least - who pay for using these instruments and also face value erosion due to inflation. More needs to be done to move to electronic payments, and soon.



Competition and innovation are both important for this goal. The document talks about the dilemma the regulator faces with regard to pricing. To us, there is no such dilemma. To a large extent, the regulator should not intervene in business decisions such as pricing. In terms of market structure, there are two types of charges in payments - by retail payment providers and by infrastructure providers in the system. At the front end, innovative and cost effective payments products and gateways can develop if there is competition and there is no case for regulatory intervention here. It is a serious issue, and as experience from credit markets would suggest, a cap on pricing usually leads to more exclusion than inclusion.



Anti-competitive actions by players can be taken up to the Competition Commission. At the same time, it is important to note that in industries that are network based, there may be a need for monopolies or duopolies in infrastructure provision which require modification of the standard approaches of competition law (example).



Under these circumstances, if there is evidence of supernormal profits, there may be role for regulating prices. But even here, price determination should be done transparently, based on a full analysis of costs and reasonable returns, and in consultation with industry participants. For example, in the recent announcement of a cap on merchant discount rate on debit cards, there is no explanation from the regulator for how the amount 0.75 per cent was decided, and what are its costs and benefits to the system.



The role for non-banks is conspicuous by its absence in the vision statement. Currently, regulations tie the hands of non-bank payment providers. Take the example of Airtel money, which is a semi-closed mobile wallet. This means money can be transferred to other Airtel customers and transactions can take place with certain merchants, but there is no possibility for cashing out. Vodafone has partnered with a bank, and hence allows cash out from retail points; but these registered points have to be within 30 km of the bank partner.



A key insight that should guide the way forward is that payments is a separate business from banking, and should have its own regulation. Decoupling them could help achieve the twin goals of innovation and inclusion. An electronic payments revolution can take place when small value transactions are done electronically, i.e., customers in every nook and corner of the country can access secure, efficient and low cost retail payments services that can be considered cash substitutes. E-money in many countries has exploded on the backs of non-bank led payments systems such as telecom companies and retail chains, and their reach has been impressive. Easing restrictions on non-bank payments systems in India is required to really take advantage of their vast networks that have already penetrated unbanked areas. There are risks, but nothing that a forward thinking regulator who recognises the immense potential cannot creatively address. (See How to achieve safety in payments for an example.)



Finally, for large value electronic payments systems, RBI's vision should be to bring them up to world standards and integrated with global systems. Cross-border payments are an important facet of international trade and integration, and this can lead to settlement/ Herstatt risks. RBI should address operational and regulatory issues to minimise these risks. For example, RTGS should be brought as close as possible to a 24 by 7 settlement system to ensure overlaps with corresponding systems in other countries and time zones.



Additionally, in light of recent data that shows that the INR is the third most traded emerging market currency, these and other steps should be taken so that the INR becomes an eligible currency for settlement in the Continuous Linked Settlement (CLS) system, alongside the other international currencies already on CLS. In conclusion, it is commendable that RBI has released a payments vision document. Such a document gives an opportunity for us to understand the mind of a government agency, and discuss and debate its priorities and actions. But writing a vision statement is a chance to step away from the familiarity of set ways and ask the big questions. RBI should not squander this opportunity.

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New moves in regulation of debit card payments

by Viral Shah.



The Reserve Bank of India has stepped in to regulate the pricing for debit card transactions. The rationale behind this regulatory change seems to be that lower transaction processing fees paid by merchants will lead to an increase in the adoption of retail electronic payments overall. Issuing banks will have to give up interchange revenue in the short run, but increased transactions will make up for lower fees in the long run. An unintended consequence could be that transaction processing gets adversely affected, and the current growth rate of retail electronic payments slows down. The RBI circular was released on June 28, 2012, and the industry is expected to comply from July 1, 2012.

Card payments background

Electronic payments are an outcome of the delicate combination of technology and incentives. A card scheme (Mastercard, Visa, etc.) brings four stakeholders together. Issuing banks issue payment cards to their customers, who become cardholders, whereas acquiring banks sign up merchants to accept card payments. The card scheme provides the interconnect between issuing and acquiring banks, so that a merchant can accept a payment from any cardholder. The diagram below shows the relationships between all participants in a payments transaction.









The service fee that merchants pays to the acquiring bank for processing transactions is called the merchant discount rate (MDR). The acquiring bank collects the MDR from the merchant and pays an interchange (I) fee to the issuing bank and a network fee (N) to the card scheme. The interchange is usually enabled by the card scheme, which guarantees revenue for the issuing bank. This incentivises the issuing bank to keep issuing more cards, and to spend on marketing and loyalty programs so that cardholders activate the cards and use card payments frequently. The MDR necessarily has to be higher than the interchange and includes the acquirer's processing fee (A), which is used to operate the card processing infrastructure. It is traditionally market determined, and is a contract between the acquiring bank and the merchant, based on the merchant's volumes, risk, chargebacks, infrastructure needs, etc.

We thus have the equation:



MDR (Merchant Discount Rate) = I (Interchange) + N (Network fee) + A (Acquirer's processing fee)



Debit card transaction volumes are growing much faster than credit card transactions, and if one extrapolates the trend from the RBI electronic payments data, it is expected that debit card transactions will have overtaken credit card transactions by volume.

Different methods of payments

Sr.	Payment Instrument	Cost	Who bears	Who earns	Volume (Million)	Value (Rs. Trillion)	Source
1.	Cheque	Rs.25-40	Bank		1,155	67	RBI 2010-11
2.	Cash (ATM)	Rs.18	Bank		3,500	10	Extrapolated from NPCI 2012 data
3.	ECS	Rs.2.50	Merchant / Biller	Issuing bank	273	2.5	RBI 2010-11
4.	NEFT	Rs.5	Customer	Issuing bank	132	9	RBI 2010-11
5.	Net Banking	Rs.7-10	Merchant / Biller	Issuing bank
6.	Credit cards	Rs.50 (average txn of Rs.3000)	Merchant / Biller	Issuing bank	265	0.75	RBI 2010-11
7.	Debit cards	Rs.25 (average txn of Rs.1500)	Merchant / Biller	Issuing bank	237	0.35	RBI 2010-11

We have a topsy-turvy world, where banks are willing to bear the cost of transactions for cheques and cash, but expect fees when transactions are processed electronically. Given that electronic payments often lead to customers keeping higher balances in their accounts, and savings on cheque processing and cash withdrawal, it would be rational for banks to incentivise electronic payments for customers and merchants alike.

Should credit card and debit card transactions have the same pricing?

Credit cards are really instruments for lending, whereas debit cards are instruments for making payments. The card transaction model evolved first in the case of credit cards, and was subsequently adopted for debit cards. In the case of credit cards, the interchange fee is used by the issuing bank to fund the cost of credit offered to the customer, and the risk of default, between the time of purchase and the time the customer pays the credit card bill. As a result, in case of a debit card transaction, one would expect (I) to be lower due to absence of credit, (A) to be similar since it is already market determined, and hence, (MDR) to be lower.



Large merchants are often able to negotiate a lower (MDR) with acquirers, even lower than (I), implying that (A) is negative. The acquiring bank offers this service to the merchant if the merchant maintains their current account with the acquirer. Clearly, this model is not scalable and does not work for the long tail of small merchants.

Should point-of-sale (POS) and e-commerce pricing be different?

Today, both credit and debit card transactions have the same MDR - roughly 1.6% for POS transactions, and 2% for e-commerce transactions. E-commerce transactions were once considered riskier with higher rates of fraud, and hence justified higher pricing. Now that two factor authentication is mandatory for internet and mobile transactions, there should be no difference in (I) and (A), and hence in (MDR) for POS vs. e-commerce transactions.

Why do regulators step in?

The card business is a two-sided platform, where the card issuing and merchant acquiring incentives are managed by card schemes. Consider the case of a new entrant in the card scheme business. The new entrant may want to lower prices to establish market share. However, if the entrant offers a lower (MDR) to merchants by lowering (I), issuers find the proposition unattractive. If the new entrant offers issuers a higher (I), merchants face a higher (MDR), and will be unwilling to accept the product. (A) is already market-decided and offers little opportunity for differentiated pricing. A new entrant can at best, charge a lower (N). These are the kinds of challenges faced by the Government backed National Payments Corporation of India (NPCI) in launching the domestic card scheme, RuPay. The issue of debit card transaction pricing was first highlighted in the public domain in the Report of the Task Force on Aadhaar-enabled unified payment infrastructure. Due to such high barriers to entry, card schemes are routinely examined by Governments, and regulators have stepped in to regulate debit interchange pricing. Regulators have typically capped (I), but in India, RBI has decided to cap (MDR). This is likely to have interesting consequences that are not easy to predict.

What will happen on July 1, 2012, when the new pricing kicks in?

On July 1, 2012, the MDR cannot exceed 0.75% for transactions up to Rs.2,000, and 1% for other tansactions. If existing contracts remain in place, then issuers are guaranteed to receive (I) (usually 1.1% or higher) and the card scheme is guaranteed to receve (N) (roughly 0.15%). In such a case, (A) becomes negative, and acquirers will lose money on every transaction they process. However, this announcement by RBI is likely to be considered a material adverse change, one expects contracts to be renegotiated. As per the data above, if debit card volumes are Rs.40,000 crore, MDR paid by merchants at 2% is roughly Rs.800 crore. The new regulation effectively means that the merchants are as a group better off by Rs.400 crore on a notional basis on July 1. The acquirers are likely to be inelastic on pricing, which means that it is issuers and card schemes that will have to largely absorb the notional loss - (I) and (N) will have to be reduced in the new regime. Much of this will be absorbed by five large issuers. Over time, as more transactions are processed electronically, banks will save on processing cheques and cash, and instead earn fees from processing electronic transactions.

Will the lower pricing due to regulation lead to higher acceptance of debit cards overall?

It is clear that merchants who were on the margin, are going to be more likely to accept card payments. It is even likely that merchants will now start demanding debit cards from customers instead of credit cards. At the same time, it is also worth noting that cards are largely accepted by merchants in metros and by e-commerce merchants. India has a network of only 600,000 POS devices and 100,000 ATMs, which is grossly inadequate for a country of our size. (A) is now likely to get fixed due to MDR being capped, and the acquiring business could start seeing stable revenues. This is also likely to lead to an interesting opportunity for the low cost merchant acquiring technologies similar to Square, a number of which are getting ready to launch in India. It could also create an opportunity for NPCI to differentiate itself from established competitors. Overall, the best case scenario is an increased demand for electronic payments with debit cards by merchants and consumers, savings for issuers due to reduced cash and cheque usage, greater acquiring revenues, and more banks entering the acquiring business (PSU Banks are notably absent in the acquiring business). At the very least, one hopes that the oil marketing companies will no longer charge a petrol surcharge fee of 2.5% when paying with a debit card.

What are the possible negative consequences of this regulation?

If (A) is set too low by the card schemes, the acquiring business will be affected. With no further bargaining power, acquirers may have to focus on cost cutting and holding back new investments. Issuing is unlikely to be affected much given the existing base of 300 Million debit cards, and that banks will continue to issue debit cards for ATM usage. One does expect cash-back schemes, loyalty programs, and various other cardholder incentives for debit products to effecively stop, and cardholder fees to increase. Even with ATM interoperability and pricing, RBI has continues to refine its policy (making interoperability mandatory at first, then free interoperable transactions, then restricting the number of free interoperable transactions to five, white labelled ATM policy, etc.). Similarly, this is likely to be the beginning and not the last word on the matter from the regulator. The policy should be stabilized quickly, since it is consumers who suffer during the experimentation phase.

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Transparency in the LPG subsidy

by href="http://ajayshahblog.blogspot.in/2012/01/author-viral-shah.html">Viral
Shah.

Recently, the Petroleum Minister launched the LPG transparency portals for all three Oil Marketing Companies (OMCs):

The Oil Marketing Companies have been constantly leveraging technology to launch various initiatives for offering convenience to their consumers For example, some of them are offering the facility for booking refill cylinders 24x7online through their websites as well as through SMS and IVRS. In continuation of their endeavor to leverage technology to achieve more efficiency and improve business processes, Oil Companies have now put in place systems to capture the complete details of customers and track their LPG consumption pattern with an aim to increase transparency in LPG supply chain. With this information, each OMC has created a transparency portal which is hosted on their individual websites. These portals can also be accessed from MOPNG's website. These portals provide complete details of each customer with their consumer numbers, name, address, no. of cylinders supplied, dates of supply as well as the indicative subsidy amount for the cylinders supplied. The portals feature quick search options to find one's distributor,sort information based on consumer numberand consumer name, see thehighest off take consumer orput in a request to surrender one's connection. Logging a complaint is just as easy. Consumers can now even rate the performance of theirdistributors; and this is expected to help the services to improve further. These portals would truly empower the consumers and civil society to verify or seek information under one roof and bring about transparency in a government program where thousands of crores of subsidy is involved.

Links for the transparency portals are:

• Indane
  
• Bharat Gas
  
• HP Gas
  

LPG distribution

The production, supply, and distribution of Liquified Petroleum Gas
(LPG) is governed by the href="http://seednet.gov.in/Material/Essential_Commodity_Act_1955(No_10_of_1955).pdf">Essential
Commodities Act, 1955 and the href="http://www.petroleumbazaar.com/Admin/ActsandControls/CO-SL-12.pdf">LPG
Control Order, 2000. The LPG Control Order specifies various
aspects of LPG distribution in great detail: storage, transport,
bottling, packaging, consumer connection, etc. Subsidized LPG is
provided largely for domestic use, but institutional use is permitted
for Government schools, hospitals, canteens, police stations,
etc. Subsidized LPG cylinders are red in colour and contain 14.2kg of
LPG, whereas commercial LPG cylinders are purple and contain 19kg of
LPG. LPG is supplied to consumers through distributors, who are paid a
commission for every cylinder they deliver. Distributors have very
thin margins for subsidized LPG, and are given distribution rights by
area by the OMC. Margins for commercial LPG are higher, with no
restrictiction on distribution. Thus, by design, there is no
competition between distributors for subsidized LPG, but commercial
LPG is supplied competitively. Almost 90% of the usage in India is
domestic, and hence subsidized.

LPG subsidy

A detailed price computation for an LPG cylinder shows that as of June 1, 2012, the consumer pays Rs.399 per cylinder in Delhi, and receives a subsidy of Rs.418 per cylinder. The true subsidy is only Rs.22 per cylinder, and the rest is termed under recovery to OMCs. The Government funds the full subsidy amount of Rs.22, but the under-recovery is funded out of profits of ONGC, OMCs, and partially by the Government. It is also worthwhile to note that LPG is exempt from Excise Duty from Central Government, and often also exempt from VAT.

Sr.	Elements (Delhi)	Unit	Effective 1st June'12
1	Free On Board Price at Arab Gulf of LPG	$/MT	852.78
2	Add: Ocean Freight from AG to Indian Ports	$/MT	43.39
3	Cost & Freight Price	Rs. / Cylinder	689.03
4	Import Charges (Insurance/Ocean Loss/ LC Charge/Port Dues)	Rs. / Cylinder	5.82
5	Basic Customs Duty	Rs. / Cylinder	0.00
6	Import Parity Price (Sum of 3 to 5)	Rs. / Cylinder	694.84
7	Refinery Transfer Price (RTP) for Domestic LPG	Rs. / Cylinder	694.84
8	Add : Inland Freight, Delivery Charges etc.	Rs. / Cylinder	39.46
9	Add : Marketing Cost of OMCs	Rs. / Cylinder	12.38
10	Add : Marketing Margin of OMCs	Rs. / Cylinder	6.68
11	Add : Bottling Charges (Filling and Cylinder Cost)	Rs. / Cylinder	38.68
12	Total Desired Price (Sum of 7 to 11) Before Excise Duty, VAT and Distributor Commission	Rs. / Cylinder	792.04
13	Less : Subsidy by Central Government	Rs. / Cylinder	22.58
14	Less: Under-recovery to Oil Marketing Companies	Rs. / Cylinder	396.03
15	Price Charged to Distributor (12-13-14) Excluding Excise Duty & VAT	Rs. / Cylinder	373.43
16	Add : Excise Duty (Including Education Cess)	Rs. / Cylinder	0.00
17	Add : Distributor Commission	Rs. / Cylinder	25.83
18	Add : VAT	Rs. / Cylinder	0.00
19	Retail Selling Price (Sum of 15 to 18)	Rs. / Cylinder	399.26
20	Retail Selling Price at Delhi (Rounded Off)	Rs. / Cylinder	399.00
21	Under Recovery due to Rounding Down	Rs. / Cylinder	0.26

The Report
of the Task Force on Direct Transfer of Subsidies on Kerosene, LPG
and Fertiliser provides some other interesting figures. There are
12.5 crore LPG connections, consuming 6 cylinders on average. The
per-capita consumption of LPG is expected to be roughly 1.5 cylinders
annually, leading to a family of four requiring 6 cylinders every
year. The total subsidy to consumers in FY09-10 was Rs.16,071 crore,
when the per cylinder subsidy was Rs.185. With the current
international oil prices being much higher, the total subsidy to the
consumers could add up to Rs.50,000 crore this year. The total
subsidy to the consumer was Rs.76 per cylinder in FY02-03, and has
steadily risen ever since to its current value of Rs.418 per
cylinder.

Benefits from transparency

The href="http://finmin.nic.in/reports/Interim_report_Task_Force_DTS.pdf">Report
of the Task Force on Direct Transfer of Subsidies on Kerosene, LPG and
Fertiliser provides a number of suggestions to address the
leakage of subsidies:

• Setting up a transparency portal
  
• Per-capita or per-connection cap on number of subsidized cylinders per year
  
• Sale of LPG at market price, with subsidy refunded to the
  consumer's bank account
  

The Ministry of Petroleum and Natural Gas, along with the OMCs,
have launched transparency portals. Even though there is no
restriction on the number of subsidized LPG cylinders that a consumer
can order, checks have been put in so that there has to be a gap of at
least 21 days between two bookings. The media has been quick to report
on the href="https://news.google.com/news/story?hl=en&gl=in&q=lpg+minister&bav=on.2,or.r_gc.r_pw.r_qf.,cf.osb&biw=1080&bih=784&um=1&ie=UTF-8&ncl=de-Hmj8GRCB9U4MJDosWh0ADdMYsM&sa=X&ei=ZyrwT4H6Cc2srAfh0eC9DQ&ved=0CDgQqgIwAg">heavy
consumption of LPG by politicians and industrialists. The
Government expects that the transparency portal will also curb the
usage of domestic LPG for commercial purposes. Many are even asking href="https://news.google.com/news/story?hl=en&gl=in&q=lpg+minister&bav=on.2,or.r_gc.r_pw.r_qf.,cf.osb&biw=1080&bih=784&um=1&ie=UTF-8&ncl=dTO4uGcZVmo8-LMIT8y73Y4KltPsM&sa=X&ei=ZyrwT4H6Cc2srAfh0eC9DQ&ved=0CC4QqgIwAQ">whether
LPG should be subsidized at all. Over the next few months, we will
learn whether LPG diversion is checked due to transparency
portals. However, the launch of other features such as rating of
dealers, online complaints, and online booking are certainly going to
be beneficial for consumers.

The Right to Information Act, 2005 has provisions that require Government to provide data electronically to citizens. Transparency portals are incredibly powerful accountability tools, and should be the first step towards e-Governance for any Ministry or Department. They take existing databases and make them available online for scrutiny, often without requiring major business process re-engineering. Rather than simply make these portals available for browsing online, care should be put in to produce high quality, anonymized, machine-readable datasets that researchers can use for various purposes. Such datasets can provide interesting insight into the microeconomics of households and also macroeconomic trends, when studied over time.

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